Study guide
This chapter completes Function 1 of the official outline, which together with Chapter 1 accounts for 37 of the 75 scored questions. The exam tests valuation at the conceptual level with light arithmetic: how each methodology works, what its inputs mean, which direction value moves when an assumption changes, and how the methods rank against one another.
Enterprise Value, Equity Value, and Multiples
Every valuation conversation starts with the distinction between equity value and enterprise value. Equity value, called market capitalization for a public company, is the value belonging to shareholders: share price multiplied by diluted shares outstanding, with in-the-money options counted using the treasury stock method, which assumes option exercise proceeds are used to repurchase stock. Enterprise value (EV) is the value of the whole business regardless of who financed it: equity value plus total debt, preferred stock and noncontrolling interests, minus cash and equivalents. Cash is subtracted because a buyer effectively receives it, reducing the true cost of the acquisition. Suppose Ridgeline Analytics trades at 40 dollars with 50 million diluted shares, carries 600 million dollars of debt and holds 200 million of cash. Equity value is 2.0 billion, and enterprise value is 2.4 billion. The pairing rule governs multiples: match the numerator to the earnings stream in the denominator. Metrics available to all capital providers, revenue, EBITDA and EBIT, pair with enterprise value, giving EV/Sales, EV/EBITDA and EV/EBIT. Metrics that belong only to shareholders, net income, earnings per share and book value of equity, pair with equity value, giving the price-to-earnings and price-to-book ratios. Mixing them, such as a price-to-EBITDA ratio, produces numbers distorted by capital structure. EV/EBITDA is the workhorse multiple in banking because it is capital-structure neutral and unaffected by depreciation policy; P/E remains common for financial institutions and for accretion/dilution work because it maps directly to earnings per share.
Comparable Companies Analysis
Comparable companies analysis, called trading comps, values a company by reference to how the stock market currently prices similar public companies. The steps are consistent. First, select a peer group of publicly traded companies that resemble the target in industry, business model, size, growth and profitability; five to ten names is typical. Second, gather each peer's market data and financials, calculate equity value and enterprise value, and compute multiples such as EV/EBITDA, EV/Sales and P/E on both a trailing and a forward-year basis. Third, summarize the range, usually focusing on the median rather than the mean so a single outlier does not skew the answer. Fourth, apply a chosen multiple range to the target's corresponding metric to imply a valuation range. If the peer median forward EV/EBITDA is 9 times and Cobalt Ferry Lines expects 150 million dollars of EBITDA next year, implied enterprise value is roughly 1.35 billion; subtracting net debt yields implied equity value. The strengths of trading comps are that they are grounded in live market prices, easy to update and easy to explain. The weaknesses: no two companies are truly identical, the market may be over- or under-pricing the entire sector at any moment, and trading multiples reflect prices for small minority stakes, so they embed no control premium. That last point matters: trading comps typically anchor the lower end of an M&A valuation range, and good analysts adjust for differences in growth and margins rather than applying the median mechanically.
Precedent Transactions Analysis
Precedent transactions analysis, or deal comps, values a company using the prices acquirers actually paid for similar companies in past M&A transactions. The mechanics mirror trading comps: assemble a set of relevant deals, compute each transaction's enterprise value and the implied multiples of the target's revenue, EBITDA or net income at announcement, then apply representative multiples to the subject company. The source documents are public: merger proxy statements, Schedule TO filings, Form 8-K announcements and press releases disclose price and terms. Because an acquirer must persuade shareholders to give up control, transaction prices include a control premium, historically often in the range of 20 to 40 percent over the unaffected trading price, though it varies widely from deal to deal. Deal prices may also embed expected synergies, the cost savings or revenue gains the buyer expects from combining the businesses. Precedent transactions therefore usually imply higher values than trading comps and anchor the upper portion of a valuation summary. The method's weaknesses flow from its data. Past deals may have closed in very different market and financing conditions; a multiple paid at the top of a credit cycle says little about today. Truly comparable deals may be scarce, terms for private targets may be undisclosed, and each transaction has idiosyncratic drivers: a distressed seller, a strategic buyer with unique synergies, or an unusually competitive auction. Exam questions commonly ask you to rank methodologies; the standard answer places precedent transactions above trading comps because of the control premium, with a DCF's position depending entirely on its assumptions.
Discounted Cash Flow Concepts
A discounted cash flow analysis values a business as the present value of the cash it is expected to generate, making it an intrinsic method rather than a market-relative one. The standard approach projects unlevered free cash flow, the cash available to all capital providers: start with EBIT, subtract taxes on EBIT, add back depreciation and amortization, subtract capital expenditures, and subtract any increase in net working capital. Cash flows are typically projected for five to ten years. Because the business keeps operating afterward, a terminal value captures everything beyond the projection window. It is computed either with the perpetuity growth method, final-year cash flow grown at a modest long-run rate and divided by the discount rate minus that growth rate, or with an exit multiple, applying a market multiple such as EV/EBITDA to the final projected year's EBITDA. Terminal value often represents well over half of total DCF value, so small assumption changes move the answer materially, which is why results are presented in sensitivity tables. The discount rate for unlevered cash flows is the weighted average cost of capital, or WACC: the cost of equity and the after-tax cost of debt, each weighted by its share of the capital structure. Cost of equity usually comes from the capital asset pricing model: the risk-free rate plus beta times the equity risk premium. Directional intuition is heavily tested: a higher WACC lowers value, a higher terminal growth rate or exit multiple raises it, and higher capital spending reduces free cash flow. Discounting the flows and terminal value gives enterprise value; subtracting net debt gives implied equity value.
LBO Basics and Accretion/Dilution Analysis
In a leveraged buyout, a financial sponsor, meaning a private equity firm, acquires a company using a large proportion of borrowed money, often half to two-thirds of the purchase price, with the target's own cash flows servicing the debt. Good LBO candidates generate stable, predictable cash flow, carry modest existing debt, own assets that can support borrowing, and offer operational improvement opportunities. Returns, measured as the internal rate of return on the sponsor's equity, come from three sources: paying down debt with the company's cash flow, growing EBITDA, and selling at a higher multiple than was paid, known as multiple expansion. Because the sponsor requires a minimum return over a hold of roughly three to seven years, the maximum price an LBO model supports is often treated as a floor valuation relative to what a strategic buyer with synergies might pay. Accretion/dilution analysis answers a different question: how a proposed acquisition changes the acquirer's earnings per share. Combine the two companies' net incomes, adjust for deal effects, after-tax interest on new acquisition debt, foregone interest on cash spent, and any new shares issued to the seller, then divide by the pro forma share count. If pro forma EPS exceeds the acquirer's standalone EPS, the deal is accretive; if lower, dilutive. A classic rule of thumb for all-stock deals: when the acquirer's P/E is higher than the P/E it pays for the target, the deal is accretive before synergies, and dilutive when the acquirer's P/E is lower. Synergies, financing mix and purchase price can flip the result in either direction.
Key terms
- Enterprise value
- — The value of the entire business independent of financing: equity value plus debt, preferred stock and noncontrolling interests, minus cash.
- Equity value
- — The value belonging to shareholders; for a public company, share price times diluted shares outstanding (market capitalization).
- Treasury stock method
- — The convention for counting in-the-money options in diluted shares, assuming exercise proceeds are used to buy back stock at the current price.
- EV/EBITDA multiple
- — Enterprise value divided by EBITDA; the standard capital-structure-neutral valuation multiple in investment banking.
- Price-to-earnings (P/E) ratio
- — Share price divided by earnings per share, or equity value divided by net income; an equity-level multiple.
- Comparable companies analysis
- — Valuing a company from the trading multiples of similar public companies; market-based, but embeds no control premium.
- Precedent transactions analysis
- — Valuing a company from the multiples paid in past M&A deals for similar companies; typically implies higher values because prices include control premiums.
- Control premium
- — The amount above the unaffected market price an acquirer pays to obtain control of a company.
- Unlevered free cash flow
- — Cash flow available to all capital providers: EBIT minus taxes, plus depreciation and amortization, minus capital expenditures and increases in net working capital.
- Weighted average cost of capital (WACC)
- — The blended required return of a company's capital providers: cost of equity and after-tax cost of debt weighted by their shares of the capital structure; the discount rate for unlevered cash flows.
- Terminal value
- — The value of all cash flows beyond the projection period, estimated with a perpetuity growth formula or an exit multiple; often the majority of total DCF value.
- Accretion/dilution analysis
- — A comparison of the acquirer's pro forma earnings per share after a deal to its standalone EPS; accretive if higher, dilutive if lower.
Exam tips
- Memorize the enterprise value bridge, equity value plus debt plus preferred plus noncontrolling interests minus cash, and expect to compute it quickly from a short fact pattern.
- Apply the pairing rule: enterprise value goes with revenue, EBITDA and EBIT; equity value goes with net income and book value. A price-to-EBITDA choice is almost always a wrong answer.
- Know the standard ranking: precedent transactions usually imply the highest values because of the control premium, trading comps the lowest, with DCF results driven by assumptions.
- Directional DCF questions are free points: higher WACC means lower value; higher terminal growth or exit multiple means higher value; higher capex means lower free cash flow.
- For all-stock deals, compare P/E ratios: an acquirer with a higher P/E than the deal P/E of the target sees accretion before synergies.