Interesting Interview question
Recently came across this question in an interview situation:
Imagine you have a company that has 2 completely different segments, doing 2 different things. The first segment has high growth and low EBITDA margins (let’s say 20% growth and 20% margins) and the second has low growth and high EBITDA margins (let’s say -5% growth and 50% margins). How do you think about what this company’s worth?
I said the following:
Sum of the parts analysis, value each portion independently. The first (high growth low margin) would probably a better candidate for a DCF, given it allows you to factor in future growth better — in a way that comps couldn’t. The second would probably be a better candidate for comps, given the stronger margin profile which indicates a possibly more mature company (meaning EV / EBITDA would probably be more relevant here). Value each portion using these methods then add them together.
This is all I said, but thinking this is too high level and that there’s more elaboration to be had here. Any thoughts?
There’s a lot of questions you need to ask before making a call. Are margins low in company 1 due to high investment in growth? Will they stabilise in the medium/long term?
For Company 2, organic EBITDA decline is a staple feature in some decently valued niches (royalties/generic pharmaceutical aggregators).
in terms of valuation, DCF often has so many assumptions already so would prefer to use it to the more “certain” organically declining segment.
So ur saying you’d prefer DCF for the -5% growth company? If so can u elaborate a bit more as to why
I think you're right in assuming doing a SOTP & valuing each division separately, but your valuation techniques at that point are a bit off. Realistically you could do DCF, LBO and comp valuations on each part, there's nothing about these that makes one better suited for comp multiples vs. a DCF (unless CF was negative). Think it's Mauboussin who has the quote "everything's a dcf"... Good article to understand that comps are just a shortcut way of "doing" a dcf.
For example in your scenario, comp multiples do allow you to factor in higher growth by applying a higher multiple to them than similar, lower growing companies. For the slower growing (declining in your case) company, there's no reason you can't use a dcf. Just because a company is growing slowly doesn't mean its future cash flows don't have value.
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