Help: few questions on technicals
I'm trying to understand the theory behind valuations a little better, beyond just memorizing the formulas. If someone could help clear these questions up for me, that would be much appreciated. Thanks!
After you find the median EV/EBITDA multiple and a relative enterprise value, how do you determine if that valuation is undervalued or overvalued? My understanding is you're supposed to then go back and look at the various financial statistics to determine if that valuation is accurate or not. For example, the comparable companies all have revenue growth rates of 10% but your target company has a growth rate of 20% (everything else equal), then the valuation should actually be higher. Is that correct? Still kind of fuzzy on the application of valuation beyond just the mechanics/formulas.
When NWC decreases, you add it back to your FCFF calculation, which leads to an increase in enterprise value. This is because you have more available free cash to all holders of capital. But when you're calculating enterprise value (equity + debt...-cash), you subtract cash which lowers enterprise value. Doesn't the two phenomenon contradict each other? One is saying more free cash, greater enterprise value. The other one is saying more cash on books, cheaper it is to buy. Or are they not actually related?
This also kind of goes back to cash when calculating enterprise value. I read that the real reason is you subtract cash is because 1) its built into equity value and 2) its a nonoperating asset. How is it built into equity value? Is it just that investors sees how much cash is on the BS and indirectly prices it into the stock price? Also what does cash being a nonoperating asset have to do with enterprise value?
In theory, you would compare operational metrics. In practice, if management of your company is projecting twice the industry average growth rate, they are probably full of $hit -- or, they better have a GOOD reason why (some sort of IP, etc). Now, margins are a bit of a different story. If the firm you are valuing has higher margins (and had demonstrated that in the past), then you could justify a higher valuation vis a vis better operational leverage.
Kind of related -- the reduction in NWC effectively frees up cash. All else equal, this would be a measurement of efficiency within a firm. When you calculate EV, you subtract cash (really, excess cash) because the implicit assumption is that a firm would not carry more cash than is necessary on the B/S. It would be invested or distributed.
dont have time to get into this one right now.
Heeb gave a pretty good summary of #1 and 2
Cash is a non-operating asset so any excess cash (not necessary for running the business) could theoretically be dividended back out to the shareholders. Therefore, it adds nothing to the "enterprise value" of a company. For example: I take out a $500mm loan and get $500mm of cash, assuming no fees. Should the EV of my company just go up by $500mm? No, because I didn't actually sell more any more products, create any new technologies, etc... in essence-- having cash doesn't increase the productive value of my company if I can't invest for returns above WACC / ROIC hurdle rates.
Cash is built into equity value because investors are valuing it @ par / paying dollar-for-dollar. Let's come up with a simple scenario: say you have Widget Co. @ market cap of $1bn, no debt, and $200mm cash on-hand, trading at 20x P / E. In this case, investors will value every dollar of cash at face value (think of a bankruptcy scenario: max loss would be capped @ 80%). However, think about the ramifications of holding cash. Your returns on $200mm cash are only going to be ~1% in the ST MM, which means as an investor, you're paying 100x P / E on $200mm, which drastically overvalues the firm compared to the value its operating assets (this also ties into the last point on EV).
Hope that helps
What's with these crazy explanations for subtracting cash? Enterprise value of a company is the price an acquirer would pay for that company right now, which is its equity value plus net debt (ex-premium and all that bs). The cash is subtracted from the debt value because it makes no sense to pay cash for cash (assuming that at least some of the price is paid for with cash). It's like saying "Here, I'll trade you my $100 for your $100". In the end you still have $100, which is readily available to do whatever the fuck you want with it.
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