Valuation

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Valuation

• Educational Presentation #6 – Hedge Funds

• 23.01.25

• Property of the ESCP Alternative Investments Society

• Sources: Breaking Into Wallstreet, Bloomberg, PitchBook, Grant Thornton, Investopedia

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Section I: Introduction and Overview

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Section I: Introduction and Overview

Overview of Valuation

• Valuation is the process of determining the present value of an asset, company, or investment • It serves as the foundation for investment decisions • Estimates fair price based on quantitative and qualitative factors

Intrinsic Valuation Relative Valuation

Definition:

Definition:

• Determines a company's true value based on fundamental financial metrics • Involves calculating the present value of future cash flows • Assesses the company's assets after accounting for liabilities

• Assesses a company's worth by comparing it to similar businesses or recent market transactions • Relies on market-driven metrics • Determines a company's relative worth in comparison to peers

Methods: Discounted Cash Flow (DCF): Projects future cash flows and discounts them to their present value using the company's cost of capital Asset-based Valuation: Focuses on estimating the company’s asset value, subtracting liabilities to determine its net worth

Methods: Comparable Company Analysis (Comps): Use of financial ratios such as P/E, EV/EBITDA, and others of comparable companies to assess valuation Precedent Transaction Analysis: Involves examining prices paid in similar recent mergers and acquisitions to infer a company's value

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Section I: Introduction and Overview

How do Hedge Funds use Valuation?

• Use valuation to identify undervalued stocks for long positions and overvalued stocks for short positions. They rely heavily on relative valuation metrics (e.g., EV/EBITDA, P/E) and sometimes intrinsic methods like DCF.

L/S Hedge Funds

• Example: An L/S fund identifies a company trading at a significantly lower multiples than its peers despite strong growth potential. It goes long in this stock, while shorting a competitor trading at an unwarranted high multiple.

• Event-driven funds with focus on M&A arbitrage use relative valuation (precedent transactions) to assess deal fairness and intrinsic valuation (DCF) to identify arbitrage opportunities.

Event-Driven: M&A Arbitrage

• Example: A fund identifies a company involved in a merger deal where the target's stock trades below the acquisition price. It buys the stock of the targeted company while shorting the acquiring company, betting the deal will close and profiting from the spread.

• Activist funds, a subset of event-driven strategies, use intrinsic valuation (DCF and asset-based valuation) to identify underperforming companies or sub-businesses and push for strategic changes to unlock value.

Event-Driven:

Activist

• Example: Elliott Investment Management acquired over $5 billion in Honeywell International's stock and urged the company to separate its Aerospace and Automation divisions. The fund argued it would simplify operations, and potentially increase the share price by 51% to 75% within two years.

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Section II: Discounted Cash Flow Analysis (DCF)

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Section II: Discounted Cash Flow Analysis (DCF)

Intrinsic Valuation DCF Overview

• Calculates the present value of a company's future cash flows • Uses a discount rate to reflect the time value of money • Combines a projection period (5-10 years) and a terminal value • Provides an estimate of the total business value

Process:

1 Calculate Free Cash Flows to the Firm (FCFFs) over the projection period (i.e. “high growth period”; approx. 5-10yrs)

2 Calculate the Terminal Value (TV) (i.e. the value of the business’ operations post “stage 1”)

3 Find the Weighted Average Cost of Capital (WACC) & discount + sum up FCFFs & TV (i.e. derive a firm’s EV)

4 Bridge from EV to EqV (find the value of the firm’s equity, i.e. value for shareholders)

5 Divide EqV by (fully diluted) # of shares to get Price per Share

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Section II: Discounted Cash Flow Analysis (DCF)

Intrinsic Valuation DCF – 1 FCFFs

1 Calculate FCFFs over the projection period (i.e. “high growth period”; c. 5-10yrs )

Free Cash Flows to the Firm (FCFFs)

FCFF = NOPAT (=EBIT * (1-t)) – CapEx + D&A ± ∆ Working Capital ± Other Non-cash Adj.

• Other Non-cash Adj.: - unrealized gains, + unrealized losses, ± deferred taxes

• NOPAT = Net Operating Profit After Tax

• T = c. 5 - 10 yrs. „high growth period“

• Infrastructure may see periods of up to 50 years

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Section II: Discounted Cash Flow Analysis (DCF)

Intrinsic Valuation DCF – 2 TV

2 Calculate the Terminal Value (TV) (i.e. the value of the business’ ops post “stage 1”)

Terminal Value =

𝑻𝑽= 𝑪𝑭𝑻∗ 𝟏+ 𝒈𝑮𝑫𝑷 𝑾𝑨𝑪𝑪−𝒈𝑮𝑫𝑷

• Option Perpetuity Growth Method (Gordon’s model):

• 𝒈𝑮𝑫𝑷= Long-term growth rate of cash flows, often linked to nominal GDP growth (conservative)

• Alternative: Inflation Rate, Industry Growth, Historical Growth, ESG – adj. Growth ( < WACC)

• Assumption: The business grows perpetually at a steady rate beyond the forecast horizon

• Suitable for businesses with predictable, stable cash flows and growth prospects

• Option Exit Multiple Method

• More common for private equity, M&A, and industries with reliable market multiples

𝑻𝑽= 𝑬𝑩𝑰𝑻𝑫𝑨𝑻∗ 𝑬𝒙𝒊𝒕𝑬𝑽 𝑬𝑩𝑰𝑻𝑫𝑨𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒆 𝐏𝐕𝑻𝑽= 𝑻𝑽 𝟏+ 𝑾𝑨𝑪𝑪^𝑻 Discount

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Section II: Discounted Cash Flow Analysis (DCF)

Intrinsic Valuation DCF – 3 WACC

3 Find WACC & discount + sum up FCFFs & TV (i.e. derive a firm’s EV)

Weighted Average Cost of Capital (WACC)

• Average cost at which a company finances its assets and minimum return investors seek when investing in a specific company

• Basic 𝑊𝐴𝐶𝐶

𝑾𝑨𝑪𝑪= 𝑬

𝑻𝑨∗𝑪𝑬𝒒𝒖𝒊𝒕𝒚+ 𝑫

𝑻𝑨∗(𝟏−𝒕)

• 𝐂𝐄𝐪𝐮𝐢𝐭𝐲= 𝐫𝐟+ 𝜷∗(𝒓𝒎−𝒓𝒇) • 𝒓𝒇: Yield 10yr−treasury bill of country of firms HQ • 𝒓𝒎: Historical avg. returns market • 𝜷∶listed on Bloomberg (BBG) OR find listed peers on AND find avg. & median 𝜷, relever to target capital structure with Hamad‘s formula 𝜷𝒖= 𝜷𝒍∗

𝟏.𝑫

𝑬∗𝟏0𝒕

67538395 3:;3793

• If public: 𝐶2345 =

5<5=> ?345 OR value-weighted YTM of its outstanding bonds

ABCD

• If private: 𝐶2345 = 𝑟@ + 𝑠𝑝𝑟𝑒𝑎𝑑(spread via calculating ICR (

C7538395 3:;3793 ) + using Damodaran’s tables)

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Section II: Discounted Cash Flow Analysis (DCF)

Intrinsic Valuation DCF – 3 WACC

3 Find WACC & discount + sum up FCFFs & TV (i.e. derive a firm’s EV)

Advanced Weighted Average Cost of Capital (WACC)

𝑾𝑨𝑪𝑪= 𝑬

𝑻𝑨∗𝑪𝑬𝒒𝒖𝒊𝒕𝒚+ 𝑫

𝑻𝑨∗𝑪𝑫𝒆𝒃𝒕∗𝟏−𝒕+ 𝑷

𝑻𝑨∗𝑪𝑷𝒓𝒆𝒇𝒔

𝐂𝑷𝒓𝒆𝒇𝒔=

𝑫𝑷𝑺𝑷𝒓𝒆𝒇𝒔 𝑷𝒓𝒊𝒄𝒆𝑷𝒓𝒆𝒇𝒔

Problems with WACC:

• Target Capital Structure is known / derivable • Target Capital Structure is assumed to be constant • Meaningful listed Comps must exist

Mid-year convention => for t=1 use 0.5 for discounting. Stub period, i.e. you don’t always value @01.01.

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Section II: Discounted Cash Flow Analysis (DCF)

Intrinsic Valuation DCF – 4 Bridge

4 Bridge from EV to EqV (find the value of the firm’s equity, i.e. value for shareholders)

Standard EV-Equity Bridge

• Enterprise Value (TEV or EV; derived through a DCF asset-side model)

- Total debt (market value) + cash & cash equivalents (= Net debt) - Preferred stock (market value / estimate, if any) - Non-controlling interests (= Minorities; market value)

= Equity Value

Alternative for listed:

Equity−Value = share price ∗total diluted # of shares outstanding

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Section II: Discounted Cash Flow Analysis (DCF)

Intrinsic Valuation DCF – 4 Bridge

4 Bridge from EV to EqV (find the value of the firm’s equity, i.e. value for shareholders)

Advanced EV-Equity Bridge

• Enterprise Value

+

= Equity

Value

}

+

±

- Total financial debt (market value; incl. hybrid instruments, leases, revolver etc.) - Cash & cash equivalents (e.g. marketable securities) - Preferred stock (market value / estimate, if any) - Non-controlling interests (= minorities; market value) - Contingent liabilities (present value, if any) - (Un(der)funded) Pension & health care liabilities (provisions) - Hybrid financing instruments (e.g. Mezzanine debt) - In-the-Money (employee) stock options/ share warrants (present value, if any) - Tax liabilities & unpaid taxes due - Change of control costs - Fair Value of non-operating assets (i.e. Excess real estate, Financial assets, Associates, Assets held for sale, Tax shields from net operating loss carryforwards) - ∆ Net Working Capital (∆ calculated with normalized N.W.C. as baseline) - (...), e.g. Deferred income / deposits received

Sources: Grant Thornton | McKinsey & Co.: Valuation (5th ed.) | https://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/debttosubtract.htm | Roedl & Partne

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Section III: Relative Valuation

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Section III: Relative Valuation

Comparable Company Analysis (Comps)

• Comparable Company Analysis (Comps) estimates a business’s value by comparing it to similar publicly traded companies • It involves identifying appropriate peer companies in the same industry and analyzing their financial metrics • By using the valuation multiples of comparable companies, Comps provides an estimate of the target company’s market value

Criteria Advantages

Disadvantages

• Market-Driven: Reflects real-time market sentiment and conditions

• Geography: With varying conditions by geography, companies should operate in the same region

• Subjective Selection: Results depend heavily on the choice of peer companies

• Simplicity: Requires less detailed forecasting compared to intrinsic valuation

• Industry: Same sector or subsector is crucial to ensure similar business models, and risk profiles

• Market Volatility: Influenced by short-term market trends, which may not reflect true value

• Widely Accepted: Trusted by market participants as a standard valuation method

• Limited Forward View: Lacks the predictive insights provided by intrinsic methods like DCF

• Financial Characteristics: To ensure accurate comparability, companies should be within a similar range for metrics like revenue, EBITDA, market cap, or growth rates

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Section III: Relative Valuation

Overview of Multiples

• Valuation multiples are financial metrics that assess a company’s value relative to performance measures like earnings or cash flow • They simplify complex financial data into ratios, making it easier to compare companies across different industries and time periods • By using valuation multiples, analysts can quickly measure a company’s relative value compared to its peers

Use Case Multiple Name Meaning

Enterprise Value (EV) / EBIT

Companies with significant CapEx

Value relative to op. income after depreciation

EV / EBITDA

Companies with minimal CapEx / D&A impact

Value relative to cash flow from operations

P / E

Financial institutions, general use

Value relative to net earnings

Equity Value / Levered FCF

Analyzing post-debt cash flow

Value relative to post-debt cash flow

EV / Unlevered FCF

Capital structure-neutral companies

Value relative to pre-debt cash flow

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Section III: Relative Valuation

Precedent Transactions

• Precedent transactions analyze valuation multiples from past mergers or acquisitions of comparable companies • This method often results in higher valuations due to premiums paid by buyers for full ownership and potential synergies • The goal is to estimate a valuation range, rather than determining an exact value

Criteria Advantages

Disadvantages

• Geography: Location of the target company (Europe, US, etc.)

• Time Sensitivity: Valuations may become outdated due to changing market conditions

• Reflects Realistic Market Value: Includes the premium buyers are willing to pay for full ownership in real-world transactions

• Industry: Focused sectors (F&B, Tech, etc)

• Financial Metrics: Revenue or EBITDA within a defined range

• Limited Data: Often dependent on publicly available information, potentially not fully disclosing transaction specifics

• Captures Market Sentiment: Considers the valuation trends and competitive dynamics at the time of the deal

• Time Period: Transactions in the approximate same region / market conditions

• Highly Comparable: When carefully selected, transactions provide relevant benchmarks for valuation

• Subjective Comparability: Differences in deal structure, market conditions, and company specifics add difficulty

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Section IV: Valuation in Practice

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Section IV: Valuation in Practice

Valuation in Practice

”Football Field Valuation” Key Takeaways:

• Valuation is about providing a range of possible values, not a precise number • The results of a valuation should be interpreted as a range of values rather than an exact figure • Football Field Chart: A visual representation of valuation ranges, showing different methodologies and their results, often with large variance

Why the Range Matters:

• Valuation accounts for different assumptions and market conditions, providing flexibility in decision-making • The output of a model doesn't determine the exact deal price, it rather serves as a guideline for what to expect The range from the 25th to the 75th percentile falls between $60.00 and $80.00 for the transactions, and from $100.00 to $120.00 for the other methods. Therefore, the company's value could be estimated anywhere between $80.00 and $120.00 per share.

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Section IV: Valuation in Practice

Ad- and Disadvantages of Methods

Advantages Valuation Method Disadvantages

Public Comps

Real market data – no assumptions

Difficult to find 100% comparable companies, difficult for smaller / more volatile companies

Precedent Transactions

Based on real market prices

Data can be inconsistent, difficult to find truly comparable transactions

Discounted Cash Flow Analysis

Focuses on long term cash generation potential

Highly reliant on future assumptions, difficult for uncertain companies

Each methodology has its own strengths and weaknesses, leading to different results. Precedent transactions often provide the highest valuations due to acquisition premiums, while public comps tend to provide mid-range values based on market comparisons. Discounted cash flow (DCF) tends to produce lower values as it relies on future assumptions, making it more sensitive to projections and uncertainties.

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Section V: Examples

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Section V: Examples

DCF Example – Free Cash Flow

1 Revenue Projections

Calculating Free Cash Flow (FCF)

2 Calculate EBIT

3 Adjust for Taxes

4 Account for Non-Cash Items

5 Adjust Working Capital

5 Subtract CapEx

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Section V: Examples

DCF Example - WACC

Calculating Weighted Average Cost of Capital (WACC)

1 Determining Cost of Debt

2 Determining Cost of Equity with CAPM

3 Calculate Capital Structure Weights

4 Combine using Weights

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Section V: Examples

DCF Example – Terminal Value and Enterprise Value

Terminal Value and Enterprise Value

1 Calculate Terminal Value

2 Discount with WACC

3 Add Terminal Value to FCFs

4 EV-Equity Bridge

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Section V: Examples

Comparable Company Analysis - Example

Example: Coca-Cola

In Practice:

• Coca Cola trades at the highest P/E and EV/EBITDA multiples amongst established beverage competitors (Pepsi & Dr. Pepper)

• Reasons for that include global brand recognition, superior margins, and diversified beverage portfolio, signalling stronger operational efficiency and lower risk

PitchBook is a popular tool for sourcing financial metrics, key multiples, and market data for public comps. It simplifies benchmarking valuations and identifying industry trends

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Section V: Examples

Precedent Transactions - Example

In Practice

1 Advanced Search

2 Select deal type (M&A)

3 Apply filters (geography, financials, industry, time)

Using the Advanced Search on PitchBook, start by selecting M&A as the deal type and apply key filters such as Geography, Industry, Financial Metrics (e.g., Revenue, EBITDA), and Time Frame to narrow your results. Once filtered, PitchBook provides details on target and buyer companies, transaction, deal values, and structures.