Valuation for Investment

Banking
Dr. Himanshu Joshi
Investment Banking 2020
Indian Institute of Management, Rohtak
 Valuation for Investment Bankers

• Comparable • Precedent • Discounted Cash

Company Transaction
Analysis Flow Analysis
Analysis M&A, IPOs, Restructuring, LBOs,
Equity Research, PIPE, IPOs, Private Equity, M&A, Restructuring PE, Venture Capital, Equity Reseach
Restructurings Transactions
 1. Comparable Company Analysis (Relative
Valuation)
Step 1. Select the Universe of the Comparable Companies
Study the Target
Identify key Characteristics of the Target for Comparison Purposes
Screen for Comparable Companies
Step 2. Locate the Necessary Financial Information
Regulatory filings (SEC, SEBI), Equity Research Reports, Bloomberg, Reuters.
Step3. Spread Key Statistics, Ratios, and Trading Multiples
Step 4. Benchmark the Comparable Companies
Benchmark the Financial Statistics and Ratios
Benchmark the Trading Multiples
Step 5. Determine Valuation
Valuation Based on EV/EBDITA
Valuation Based on PE
2. Precedent Transaction Analysis
Step 1. Select the Universe of Comparable Acquisitions
Screen for Comparable Acquisitions
Examine other considerations
Step 2. Locate the Necessary Deal Related and Financial Information
Public Targets
Private Targets
Step 3. Spread Key Statistics, Ratios, and Transaction Multiples
Benchmark the Financial Statistics and Ratios
Benchmark the Trading Multiples
Step 4. Benchmark the Comparable Acquisitions
Step 5. Determine Valuation
3. Discounted Cash Flow Valuation
Step 1. Study the Target and Determine Key Performance Drivers.
Study the Target
Determine Key Target Drivers
Step 2. Project Free Cash Flow
Considerations for Projecting Free Cash Flows
Projection of Sales, EBITDA, and EBIT
Projection of Free Cash Flow
Step 3. Calculate Weighted Average Cost of Capital
Determine Target Capital Structure
Estimate Cost of Debt
Estimate Cost of Equity
Calculate WACC
3. Discounted Cash Flow Valuation
Step 4. Determine Terminal Value
Exit Multiple Method
Perpetuity Growth Method
Step 5. Calculate Present Value and Determine Valuation
Calculate Present Value
Determine Valuation
Perform Sensitivity Analysis
Discounted Cash Flow Valuation
Step 1. Study the Target and Determine Key Performance Drivers.
• Study and learn as much as possible about the target and its sector.
• Shortcuts in this critical area of due diligence may lead to misguided
assumptions and valuation distortions later on.
• The exercise involves determining the key drivers of financial
performance such as Sales Growth, Profitability, and FCF Generation,
which enables to develop defensible set of projections for the target.
• Step 1 is invariably easier when valuing a public company as opposed to
a private company due to the availability of information from sources
such as regulatory filings, equity research reports, earnings call
transcripts, and investor presentations.
Discounted Cash Flow Valuation
Step 1. Study the Target and Determine Key Performance Drivers for
Private Companies…
For Private, Non-Filing Companies, bankers often rely on company
management to provide materials containing basic business and financial
information.
In the absence of this information, alternative sources such as Company
Websites, Trade Journals, News Articles, Regulatory Filings, and Research
Reports for Public Competitors, Customers, and Suppliers must be used to
learn basic company information and form the basis for developing the
assumptions to drive financial performance.
Discounted Cash Flow Valuation
Step 2. Project Free Cash Flow – The Projection of the target companies
unlevered FCF forms the core of a DCF.
Unlevered FCF = EBIT(1-Tc) + Depreciation –Capital Expenditure – Increase in
Net Working Capital
FCF is driven by assumptions underlying its future financial performance,
including sales growth rates, profit margins, capex, and working capital
requirements.
Historical performance, combined with third party and/or management
guidance, helps in developing these assumptions.
The use of realistic FCF assumption is critical as it has the greatest effect on
valuation in a DCF.
Discounted Cash Flow Valuation
Step 3. Calculate Weighted Average Cost of Capital.
Determine Target Capital Structure
For public companies, existing capital structure is generally used as the
target capital structure as long as it is comfortably within the range of
the comparable. If it is at the extreme of, or outside, the range, then
median for the comparable may serve as better representation if the
target capital structure.
For private companies, the median for the comparable is typically used.
One can assume a fixed target capital structure for the valuation period
or may update the same based on new information.
Discounted Cash Flow Valuation
Estimate Cost of Debt

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑖𝑑 𝑜𝑛 𝐷𝑒𝑏𝑡 (𝑅𝑠.)

1. Cost of Debt = * (1 – Tax Rate)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝐷𝑒𝑏𝑡
OR
2. Cost of Debt = { Risk Free Rate + Default Spread }* (1-Tax Rate)
Default Spread on the comparable credit rating recent bond issuance.
Seniority Ranking of Various Debt Issued by a
Company..
First Lien Loan

Senior Secured

Senior Unsecured

Senior Subordinated

Subordinated

Junior Subordinated
Discounted Cash Flow Valuation
Estimate Cost of Equity
Cost of Equity - Risk and Return Model Approach
• Risk is defined in terms of the distribution of actual returns around
and expected return.
• Differentiate between the risk that is specific to one or few
investments and the risk that affects a much wider cross section of
investments.
• In a market where marginal investor is well diversified, it is only the
“market risk” that will be rewarded.
Diversifiable and Non Diversifiable Risk.
Exchange Interest
Competition Rate and Rates,
may be stronger or
weaker than the Political Risk Inflation
Project may do expected Entire Sector and news
better or Worse may be about
than expected
affected by economy
Firm Specific action Market

Affects Few Firms Affects Many firms

 CAPM the Default Model
• Expected Return on Asset i = Risk Free Rate +
Beta of asseti *(Risk Premium for Average-Risk Asset).

• CAPM Model:
Ke = Rf + β* (Rm – Rf)
Covariance Market Risk Premium
Risk Free Rate
Determinants of Betas
1. The type of business or businesses the firms is in. (cyclicality)
2. The degree of operating leverage.
3. The firm’s financial leverage.
The Leveraging Effect..Levered Beta.xlsx
• If all of the firm’s market risk is borne by the stockholders (i.e., the
beta of debt is zero), and debt creates tax benefit to the firm, then:
• βL = βU [ 1 + (1-t)* D/E]
• Where βL = levered Beta, βU = Unlevered Beta
• D/E = Debt- Equity ratio (Market Value Terms), t = tax rate.
Approach 2. Bottom Up Betas..
• Breaking Down betas into their business, Operating Leverage, and
financial leverage components provides us with an alternative way of
estimating betas, where we do not need historical returns on an
assets to estimate its beta.
• Property: The beta of two asset put together is a weighted average
of the individual asset betas, with the weights based on the market
value.
 Bottom Up Beta Estimation..(for Privately
Owned Companies)
1. Identify Comparable Firms in industry.
2. Beta Estimation using Common Index for comparable firms
βL
3. Un-lever the average Beta βU =
(1 + (1−Tc)∗ D/E)
4. Averaging Approach (Simple or Weighted Avg.)
5. Adjustment for Cash
βU
(Unlevered Beta corrected for Cash =
(1−Cash/Firm Value)
6. Calculate Levered Beta for the Firm
βL = βU * (1 + (1-Tc)* D/E)
7. Readjustment for the Cash Effect
βL = βL * (1-Cash/Firm Value)
Blank PPT for Discussion
Blank PPT for Discussion
Private and Closely Held Business..
• Adjust the Beta to Reflect Total Risk rather than just the market risk.

Market Beta
• Total Beta =
√R2
Blank PPT for Discussion
Discounted Cash Flow Valuation

• Calculate WACC = KdT * WD + Ke * WE

Discounted Cash Flow Valuation
Step 4. Determine Terminal Value
Exit Multiple Method  What is the expected Value of P/E or
EV/EBIDTA Multiple on the Terminal Year!

Perpetuity Growth Method 

FCFFT+1
Terminal Value VT =
WACC−g
 Discounted Cash Flow Valuation
Step 5. Calculate Present Value and Determine Valuation
• Calculate Present Value 
𝑛 FCFFT VT
Value of Firm’s Operating Assets = σ𝑡=1 +
(1+WACC)T (1+WACC)T
Determine Valuation 
• Value of the Firm = Value of Operating assets + Cash and Non operating
Assets
Perform Sensitivity Analysis 