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Page 1: Valuation Presentation 110929211642 Phpapp01 Copy

Valuation

II BThe Investment Banking Institute

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2II BThe Investment Banking Institute

II BThe Investment Banking Institute

Table of Contents

Discounted Cash Flow (DCF) AnalysisV.

Precedent TransactionsIII.

Comparable Public CompaniesII.

ConclusionsVI.

I. Valuation Overview

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What Is Valuation?

� How much is Computer Retailer Company A worth? (i.e. what is itsvaluation?)

� Company A will have different values to different buyers� Would the following buyers be willing to pay more or less for a piece

of the Company’s equity?¾ An individual or fund looking to buy stock in the public market and be a

minority shareholder (i.e. does not have much influence on the company’s management, operations, strategy, etc., other than the occasional shareholder vote)

¾ A competitor looking to acquire 100% of the company and merge it into its own company, with the intention of attaining synergies such as price increases to customers, operational efficiencies, savings from shutting down one corporate headquarters and firing redundant employees, etc.

¾ A private equity firm that wants to buy 100% of the company for its own investment portfolio, and therefore have strong influence and control over the company’s management team, strategy, operations, etc.

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What Is Valuation? (cont.)

� If Company A is listed on a stock exchange and its equity shares are publicly traded, then you can derive its valuation (i.e. how much it is worth) based upon the share price and other publicly available information such as SEC filings, research reports and press releases¾ This is the “Public Market Valuation”

� The “Public Market Valuation” provides one perspective on the Company’s valuation: it illustrates at what price minority shareholders are willing to buy and sell the equity shares of that company

� In addition to the Public Market Valuation, there are three methodologies commonly used to derive a company’s valuation, providing three different valuation perspectives:¾ (1) Comparable Public Companies (aka Trading Multiples)¾ (2) Precedent Transactions (aka Acquisition Multiples)¾ (3) Discounted Cash Flows (“DCF”)

� These three methodologies allow for the valuation of both publicly traded companies and privately held companies, provided you have some or all of the following information for the company that you want to value:¾ Recent income statement information (Revenues, EBIT, EBITDA, Net Income, etc.)

for the company that you want to value¾ Recent balance sheet information (cash balance, debt balance, minority interest

balance, preferred and common equity information, number of equity shares outstanding, etc.)

¾ Projected income statement information (for next 1 – 2 years)

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What Is Valuation? (cont.)

� Every transaction requires an understanding and agreement of a company’s fair market value (FMV)¾ What is FMV?

– Price at which an interested, but not desperate, buyer is willing to pay and an interested, but not desperate, seller is willing to accept on the open market

– How is this different from book value?¾ What is market value of equity (MVE)?

– MVE or market cap = price per share x total shares outstanding– MVE vs. stockholder’s equity on the balance sheet

� MVE ำ aggregate value¾ MVE represents only the value from stockholders¾ What about the value contributed by other stakeholders?¾ Aggregate or total enterprise value (TEV) is the value attributed

to ALL providers of capital

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Total Enterprise Value (TEV)

� Company valuations are performed for the purpose of determining the value of the operations¾ Does not focus on value to specific stakeholders (e.g. MVE)¾ Ignores leverage¾ Think of real estate to differentiate between TEV and MVE:

– House value = TEV; home equity = MVE; mortgage = debt

� TEV = MVE + debt + preferred stock + minority interest – cash¾ Share Price = $50.00¾ Shares Outstanding = 200 million¾ Preferred Stock = $0¾ Debt = $2,000 million ¾ Minority Interest = $0¾ Cash = $500 million¾ TEV = ?

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Total Enterprise Value (TEV) (cont.)

� Remember, common stock, preferred stock, debt and minority interest are ALL providers of capital (right-side of the balance sheet)

� What is minority interest and why is it included in TEV?¾ If you own more than 50% but less than 100% of another entity,

you are required to consolidate its financials on to your company financials. Minority interest represents the portion of equity that your company does not own – it is a liability

¾ Therefore, in a TEV / Revenue calculation, if your denominator represents a fully consolidated operating figure, it is necessary to gross up your numerator (TEV) to keep the equation balanced or “apples to apples”

¾ In a leveraged multiple such as P/E, this adjustment is not a concern because the earnings calculation is net of minority interest (i.e. minority interest expense has already been taken out)

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Total Enterprise Value (TEV) (cont.)

� Why do we subtract cash in the TEV calculation?¾ Common misconception: cash is netted against debt¾ Cash sitting on the books is not a contribution of value to the

enterprise or operations– However, cash is a contribution to MVE (i.e. value to stockholders)– Therefore, because cash is in MVE, which is a component of TEV, we

need to subtract cash

¾ To further understand the exclusion of cash, think of two (2) runners of equal ability– Runner 1 has $5.00 in his pocket– Runner 2 has $100.00 in his pocket– Is Runner 2 necessarily a better or more valuable runner than

Runner 1?

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Table of Contents

Discounted Cash Flow (DCF) AnalysisV.

Precedent TransactionsIII.

Comparable Public CompaniesII.

ConclusionsVI.

I. Valuation Overview

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Comparable Public Companies

� You can value a company based on how similar companies trade in the public markets

� The first step is to pick the comp universe (size depends on relevance)¾ The goal is to find companies of similar:

– Industries– Business Models– Profitability– Size– Growth– Geography (International vs. Domestic)

¾ Sources include:– Equity research reports– “Competitors” section from 10-K– SIC codes– Internet– Senior bankers

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Multiples Analysis

� Relative valuation is a method based on applying multiples¾ A valuation multiple is a ratio between a value and an operating

metric (financial institutions may look at balance sheet metrics)– For example: P/E ratio; price = value, earnings = operating metric – Therefore, with a given multiple and a variable, you can determine

the missing variable– P/E = 25.5x, Earnings = $30 million; MVE = ?

� There are two (2) types of trading multiples¾ Operating (debt-free)¾ Equity

� Operating (debt-free) multiples¾ TEV / Revenue, EBIT or EBITDA¾ TEV = $11,500M; Revenue = $19,426M; EBITDA = $1,369M¾ Revenue Multiple = 0.59x¾ EBITDA Multiple = 8.4x

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Operating Multiples

� Why is TEV a part of operating multiples and not MVE?¾ “Apples to Apples”¾ Remember, TEV ignores specific capital contribution ¾ Line items before interest are considered debt-free¾ MVE is value to only stockholders and is affected by leverage

� Let’s say our subject company, a widget maker, has annual financials of the following:¾ Revenue: $19,426 million¾ EBITDA: $1,369 million

� Mean trading multiples for publicly-traded widget companies¾ TEV / Rev: 0.74x¾ TEV / EBITDA: 10.3x

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Operating Multiples (cont.)

� What’s is our company’s implied TEV?¾ Revenue: $19,426 million¾ EBITDA: $1,369 million¾ Implied TEV using revenue multiple = $19,426 million * 0.74x =

$14,375 million

¾ Implied TEV using EBITDA multiple = $1,369 million * 0.74x = $14,101 million

¾ Average Implied TEV = average ($14,375 million, $14,101 million) = $14,238

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Equity Multiples

� Unlike operating multiples, equity multiples are a function of MVE

� Since the general public owns common stock and not other types of securities, analysts speak in P/E ratios¾ Price per Share / Earnings per Share¾ Market Cap / Earnings

� Again P/E is a function of MVE, which is not a good indicator ofcompany valuation

� Equity multiples require the denominator to be below the interest line (i.e. net income)¾ Again, “Apples to Apples”¾ Wrong: TEV / Earnings¾ Wrong: Market Cap / EBITDA

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“Spreading” Comps

� Spreading comparable public companies and precedent transactions require an “apples to apples” comparison¾ Same time frame – Last Twelve Months (“LTM”), Fiscal Year End

(“FYE”) or latest quarter annualized (“LQA”)– Always use most recent financials– Companies have different fiscal year-ends

¾ Normalizing numbers – adjusting EBIT, EBITDA and net income– Normal operating status– Back-out non-recurring items (operating vs. non-operating)– Include certain recurring items (operating vs. non-operating)– Continued vs. discontinued operations

� Forward-looking numbers are very important¾ Many growth industries (e.g. technology) only look at FYE+1 or +2¾ Historical performance is not an indicator of future performance¾ Projections are sourced from management and equity/high

yield/credit research reports

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“Spreading Comps” (cont.)

� Calculating TEV¾ All components need to be at fair market value

– MVE = current share price x fully diluted shares outstanding*– FMV of preferred stock = public market price or liquidation preference

(notes)– FMV of debt = generally face value unless distressed (balance sheet)– FMV of minority interest = what is stated on balance sheet– FMV of cash = what is stated on balance sheet

*discussed on following pages

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“Spreading Comps” (cont.)

� Calculating Fully-Diluted Shares¾ Basic vs. fully-diluted (FD) shares outstanding

– Dilution is built into the stock price9 if dilutive securities are “in-the-money”, the market assumes that the

securities are already converted to common stock9 A convertible security or option is “in-the-money” if the current share price

is greater than the strike price

– Dilutive securities include:9 Options9 Warrants9 Convertible preferred stock or debt (do not double-count if already

converted)

¾ Market Capitalization and TEV should always be calculated using fully-diluted shares– Using basic shares outstanding will undercut the valuation, sometimes

significantly– In certain industries where options are a large part of employee

compensation and incentive, the amount of dilutive shares can besizeable

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“Spreading Comps” (cont.)

� There are two (2) generally accepted methods for calculating dilutive shares 1. Weighted-average dilutive shares assumed by management2. The Treasury Stock Method (TSM)

1. Weighted-average dilutive shares¾ Looks at the weighted-average number of new shares created

from unexercised in-the-money warrants and options over a period of time– Commonly used in the calculation of diluted EPS– Applies greater weight to those periods of higher earnings – Does not provide an accurate spot account of the total number of in-

the-money securities

¾ Located in the EPS note of the notes section– Most recent account of dilutive data (available in the 10Q and 10K)– Lack of transparency or support - based on management discretion– Ignores the effect of proceeds received from exercising dilutive

securities

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“Spreading Comps” (cont.)2. The Treasury Stock Method (TSM)

¾ The net of new shares potentially created by unexercised in-the-money warrants and options

¾ This method assumes that the proceeds that a company receives from an in-the-money option exercise are used to repurchase common shares in the market

¾ TSM = Exercisable Options Outstanding x (Share Price - Strike Price) / Share Price– Exercisable Options Outstanding is only found in the Options Table in

the notes section of the 10K9 Full-year lag between a new set of updated options information

– Exercisable Options Outstanding represents the portion of Total Options Outstanding which is vested or earned9 Note: Total Options Outstanding is used in the TSM for Precedent

Transactions due to change of control provisions (to be explained in the next section)

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“Spreading Comps” (cont.)2. The Treasury Stock Method (TSM) (cont.)

¾ TSM does not account for in-the-money convertible preferred or convertible debt– This must be calculated separately by figuring out the conversion

prices or conversion ratios of each of the convertible securities9 Conversion prices or conversion ratios are always detailed in the bond

indenture or birth document of a convertible security and oftentimes in a 10K

– If convertible securities are in-the-money, they are converted in equity as a form of dilutive securities

– In the calculation of TEV, be careful not to double count pre-converted and post-converted values of the same security9 The conversion of a convertible security into equity means that its pre-

converted form can no longer exist9 For example, if you convert $500 million of convertible debt into dilutive

shares, you must remember to remove $500 million from total debt

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“Spreading” Comps (cont.)

� Best Buy Co. Comp Spread Example

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Selecting Multiples and Ranges

� Selecting multiples for implied valuation¾ Eliminate outliers¾ Average (mean) vs. median¾ Total versus stripped averages¾ Upper and lower quartiles

� Risk Rankings¾ Emphasis towards companies with closer business models, size,

growth and profitability, etc.

� Identifying meaningful implied valuation ranges¾ Not too narrow, not too broad¾ Be consistent

� Public vs. private value¾ Liquidity discount¾ Research coverage

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Table of Contents

Discounted Cash Flow (DCF) AnalysisV.

Precedent TransactionsIII.

Comparable Public CompaniesII.

ConclusionsVI.

I. Valuation Overview

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Precedent Transactions

� Another form of relative value is precedent transactions¾ Many argue the most accurate way of determining valuation is

observing what has been recently paid for comparable businesses in the same space– Rather than looking to the public markets for comparable company

valuations, you look at valuations based on acquisitions

¾ Again, this is a multiples-based valuation (operating and equity multiples)– Multiples which are derived from these transactions are applied to a

company’s operating statistics to determine valuation

¾ Precedent transactions yield an acquisition or control premium (approx: 20-25% depending on the industry)– Remember to adjust for minority interest-based valuations

� Selecting comparable transactions¾ Target company characteristics¾ Transaction parameters¾ Time frame

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Precedent Transactions (cont.)

� Data sources:¾ SDC or other M&A databases¾ SEC filings¾ Equity research reports¾ Press releases (company or third-party)¾ Industry news

� Typical information¾ Announce date vs. transaction date

– The price at which a transaction closes at can sometimes be materially different from the original price offered at announce date

– The spread can be associated to:9 Change in target or acquirer stock price9 Transaction-related adjustments

– Considerations should be independent of unforeseen price fluctuations and transaction-specific costs

¾ Target and acquirer descriptions

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Precedent Transactions (cont.)

� Typical information (cont.)¾ Transaction rationale

– What are the business decisions for this acquisition9 Product expansion, cost synergies, technology integration, etc.

– What are the financial decisions for this acquisition9 Under-valued stock, poor capitalization, turn-around candidate, etc.

¾ What is the consideration and structure– 100% cash– 100% acquirer’s stock

9 Exchange Ratio: The number of shares of the acquiring company that a shareholder will receive for one share of the target company.

– Combination of cash and stock9 Each share of target company will receive $12.65 in cash and 1.45 shares of

acquiring company9 What is the consideration if there are 24 million target shares outstanding

and the acquiring company’s stock price is worth $6.55 at announce date?

– Earn-out provisions9 Portion of the consideration withheld until operational milestones are

achieved

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Precedent Transactions (cont.)

� Typical information (cont.)¾ Implied TEV and MVE¾ Selected financial and operating information¾ Implied valuation multiples¾ Market premiums

– Purchase price divided by the (i) 1-day, (ii) 5-day and (iii) 30-day average stock price prior to announce date

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Table of Contents

Discounted Cash Flow (DCF) AnalysisV.

Precedent TransactionsIII.

Comparable Public CompaniesII.

ConclusionsVI.

I. Valuation Overview

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Discounted Cash Flow Overview

� The DCF calculation represents a company’s “intrinsic” value¾ Takes all cash flows projected into the future (infinitely) and

discounts it back to present value

•Identify components of FCF

•Keep in mind historical figures

•Project financials using assumptions

•Decide # of years to forecast

Forecasting Free Cash Flows

•Perform a WACC analysis

•Develop target capital structure

•Estimate cost of equity

Estimate Cost of Capital

• Determine whether to use cash flow multiple (i.e., EBITDA multiple) or growth rate method (i.e., Gordon Growth Method)

• Discount it back to present value

Estimating Terminal Value

•Bring all cash flows to present value

•Perform sensitivity analysis

• Interpret results

Calculating Results

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Pros and Cons of Discounted Cash Flow

� DCF is more flexible than other valuation methodologies. However, it is very sensitive to the estimated cash flows, discount rate and terminal value

•Objective framework for assessing cash flows and risk

•Not dependent upon publicly available information

PROS

•Very sensitive to cash flows

•Unbalanced valuation weight to terminal value

•Cost of capital depends on beta and market risk premium

CONS

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Discounted Cash Flow (DCF) Analysis

� Free cash flow (FCF) represents cash flow to ALL stakeholders, hence it is a depiction of TEV¾ Unlevered value of the firm that is independent of its capital

structure or also known as “debt free”¾ FCF = EBIT

less: TaxesIncrease/(decrease) in working capital (WC)Capital expenditures (CapEx)

plus: Depreciation and Amortization¾ Notice the “before interest” designation in EBIT¾ Value of Equity = TEV from Operations – Net Debt

� A DCF typically projects five (5) years of FCF plus a terminal value but it can be longer or shorter

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Terminal Value

� The terminal value represents the value of an investment at the end of a period, taking into account a specified rate of interest (perpetuity)¾ In other words, it looks at a company’s cashflow projected

infinitely into the future at a particular growth rate¾ There are two (2) generally accepted methods for calculating the

terminal value1. Gordon Growth Model2. Terminal Multiple

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Terminal Value (cont.)

� Wall street utilizes the terminal multiple¾ Applying a debt-free multiple (typically TEV / EBITDA) to the ending

year’s operating statistic

¾ Apply the LTM multiple if using the cash flow multiple method– Terminal Value = (LTM Multiple from Comps) x (EBITDA)

¾ Certain industries may require the use of Revenue, EBIT or Net Income multiple

� The Gordon Growth Model is exactly what the definition of terminal value states

¾ It is a constant rate projected forward - a perpetuity¾ Terminal Value = (Ending Cashflow x (1 + Growth Rate)) / (Discount

Rate - Growth Rate)¾ Good “sanity check” when backed into Terminal Multiple approach

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Cost of Capital

� Future cash flows need to be discounted at an appropriate rate in order to calculate present value¾ PV = FCF / (1 + discount rate)^year¾ DCF = PVFCF(1) + … + PVFCF(5) + PV Terminal Value

� Cost of capital (aka, discount rate) is an investor’s required rate of return or opportunity cost for investing in a particularrisk profile¾ That is to say, “what return would I require in another investment

of similar risk?”¾ Higher risk = higher required return

� The cost of capital should match the cash flows to be discounted¾ Leveraged cash flows vs. debt-free cash flows

� Common sense is the most important factor in determining the appropriate cost of capital

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Cost of Capital (cont.)

� The discount rate is expressed in two (2) basic forms:¾ (1) Cost of equity¾ (2) Cost of debt¾ Cost of preferred stock is included as a hybrid between the two

� Due to the combination of these two (2) types of capital on a company’s balance sheet, the discount rate is usually referred to as the weighted average cost of capital (WACC)

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Weighted Average Cost of Capital (WACC)

� The WACC represents the required rate of return for the overall enterprise¾ It is simply a weighted average of the required rates of return for

each of the different sources of capital (equity and debt)¾ WACC = [Ke x (E/(E+D)] + [(Kd x (D/(E+D)) x (1-T)]

– Ke = cost of equity– Kd = cost of debt– E = MVE of subject company– D = FMV of debt (same as face value unless distressed) of subject

company– T = tax rate

� Company-specific risk¾ Size risk¾ Key-man risk¾ Business model or projection risk

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Cost of Equity

� The cost of equity is calculated using the capital asset pricingmodel (CAPM)

� CAPM = Rf + Beta x (RM – Rf)¾ Rf = risk-free rate (10, 20 or 30 year treasury notes)¾ RM = market rate (Expected return on the market portfolio)¾ RM – Rf = market risk premium (return above the risk-free rate)

– Calculated by taking an average of data points over many years in order to incorporate a large sample of events

– Most banks get this rate from Ibbotson Associates (source for risk premium)

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Cost of Equity (cont.)

� Beta is the measure of volatility, or systematic risk, of a security compared to the market as a whole (e.g. S&P 500)¾ Beta of 1 signals that 1% rise in the market translates into 1% rise

in the stock¾ Beta of -1 signals that 1% rise in the market translates into 1%

decline in the stock

� Betas outside of a range of 0.5 to 2.5 should be reviewed for reasonableness

� Firms use 2 year betas to 5 year betas

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Cost of Equity (cont.)

� Levering and un-levering beta¾ Beta is a function of risk affected by leverage¾ In order to make an “apples to apples” comparison among

company returns, leverage needs to be removed from beta¾ The un-levered beta (mean) should be re-levered with the subject

company’s capital structure (i.e. debt to equity ratio)– BL = Bu x [1 + D/E x (1-T)]– Bu = BL / [1 + D/E x (1-T)]

9 BL = Levered Beta9 Bu = Unlevered Beta9 T = Tax Rate9 D = Market Value of Debt9 E = Market Value of Equity

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Cost of Debt

� Similar to the cost of equity, the cost of debt represents the return a lender would require in a security of similar risk¾ All things being equal, the cost of debt is lower than the cost of

equity for the following two (2) reasons:– (1) Senior to equity Æ less risk and therefore less required return– (2) Interest is paid out before taxes

¾ Under certain situations where a company is over-levered, raising debt may be more expensive due to default risk

� There are two main categories of debt which may be valued separately¾ Non-convertible debt (includes capital leases)¾ Convertible debt, which can be treated as equity if the

convertible is in-the-money and as debt if it is out-of-the-money

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Cost of Debt (cont.)

� A company’s overall cost of debt is calculated by averaging (weighted) the coupon rates of its various pieces of debt and multiplying it by the tax shield (1 - tax rate)¾ $500M of 8.25% senior notes due 2010¾ $250M of 9.00% senior notes due 2012¾ $300M of 12.5% senior subordinated notes due 2012¾ Tax rate of 40%¾ Cost of debt = 9.64% x (1-.40) = 5.79%

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Homework

� Best Buy Co., WACC example� Best Buy Co., DCF example

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Table of Contents

Discounted Cash Flow (DCF) AnalysisV.

Precedent TransactionsIII.

Comparable Public CompaniesII.

ConclusionsVI.

I. Valuation Overview

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Conclusions

� Highly sensitive to discount rate and terminal multiple� “Hockey Stick”

tendencies –projection risk

� Represents intrinsic value

Discounted Cash Flow (DCF)

� Poor disclosure on private and small deals� Hard to find “good”

comps in niche or slow M&A market

� Arguably, the most accurate method

Precedent Transactions

� Size discrepancy� Liquidity difference� Hard to find “good”

comps in niche market

� Highly efficient market� Easy to find

information (public access)

Comparable Public Companies

ConsPros