Guys, it does help if you read the problem. Also, while you are allowed to make assumptions, it helps to stick with the information that is already given. Your equity is what you pay for the company, not the existing equity based on historical cost. Company A price tag is 5X EBITDA or $100 million, and B is 6X EBITDA or $120 million. That is YOUR equity invetsment that you need to earn a return on. Like in the real world when a company buys another company. The $20 and $40 equity numbers are only important in that they help you get an idea of the cap structure of the company, and perhaps a view of relative ROAs of the two choices.
Your right! FirmA: $20MM when firm worth 5xEBITDA = $100MM ($80MM in debt, $20MM in equity) $25.53 now the firm is worth 5xEBITDA = $127.65 ($80MM in debt, $47.65MM in equity) ROE = (47.65-20)/20 = 138% FirmB: $20MM when the firm worth 6xEBITDA = $120MM($80MM in debt, $40MM in equity) $32.21 now the firm is worth 6xEBITDA = $193.26($80MM in debt, $73.26 in equity) ROE = (73.26-40)/40 = 83% My calculation before ignores the price!..lol
Assume EBITDA growth mirrors Revenue growth (all costs: cogs, sg&a, depreciation, interest expense, etc are constant)… Ebitda for co. A will be lower than ebitda for co. B If so, EV/ebitda of Co. A > Co. B, giving A a higher valuation. Net income for Co. B > Co. A because revenue growth is higher, and costs are the same. ROE depends on NI and Equity. Equity for Co. A > Co. B ROE for A and B will depend on the size of NI and Equity. A has NI (or EBITDA for simplification purposes) of 25.52, B has NI of 32.2. A has Equity of 20 and A has equity of 40. ROE (A) = 25.5/20 = 127% ROE (B) = 32.2/40 = 80% Hence A>B when calculating ROE as well.
guys, firm B returns more… Bsilva your firm b calculation was wrong (although you were right with firm a. FirmA: $20MM when firm worth 5xEBITDA = $100MM ($80MM in debt, $20MM in equity) $25.53 now the firm is worth 5xEBITDA = $127.65 ($80MM in debt, $47.65MM in equity) ROE = (47.65-20)/20 = 138% FirmB: $20MM when the firm worth 6xEBITDA = $120MM($80MM in debt, $40MM in equity) $32.21 now the firm is worth 6xEBITDA = $193.26($80MM in debt, $113.26 in equity) ROE = (113)/40 -1 = 183%
strikershank you have no idea what you are talking about.
Kide, what are you talking about. run the numbers. Bsilva didn’t incorporate the right equity amout firm b into his calculation. Usuing his numbers you get an enterprise value of $156mln, not the correct $193mln. using the right equity value of $113mln and debt of $80mln you get a bigger ROE for firm B.
numi, I sent you my answer by email. But if any of you are interested, I got Firm B. Assume: buyout and takeout multiples are equivalent, EBITDA margin is flat, no debt paydown. This gives an IRR to the equity investor of 23% and ROI 2.8x vs. 19% and 2.4x for Firm A. Calculation of ending Equity = 6 x (20 x 1.1^5) - (4 x 20) = 113.3
numi Wrote: > > + You can’t price these assets without knowing > > expected growth after year 5, so you’ll need to > > assume something here. > > That’s fine, I should have mentioned earlier that > you’re exiting the investment at year 5. VOBA: > Assume: buyout and takeout multiples Again, you can’t price the t=5 firm without knowing its growth prospects. Here VOBA assumes the 5% and 10% growth numbers recur. 10% eternal growth is beyond usual ranges.
Good observation, Darien. However, in most LBO exit situations, the deal will be priced on an EBITDA multiple so to that end, what really matters is the EBITDA in year 5 along with the value of debt or equity at that time. The reason for this is because the company’s growth prospects will be captured in the multiple at exit (no different from P/E, P/S, or whatever other valuation metric you choose to use). It’s true that the question doesn’t tell you what the exit multiple for each company might look at, but because nobody really knows whether the multiple will contract or expand down the line, it’s generally presumed that you will exit at the same EV/EBITDA multiple as you entered (though bankers will certainly try hard to create “multiple expansion” for the investment by way of picking attractive comps). Thus, I think VOBA’s assessment is still reasonable from the perspective of an LBO investor. What are your thoughts on this? I agree that it’s not the perfect system (and some would argue that deal valuation is just a bunch of hooey), but this is just a common way of doing exit valuation in buyout situations. (You mentioned in an earlier post that you were in banking so I assume you must have seen this?
By just looking, I’d say B would have a much higher IRR at the point of exit. Here’s why: First let’s look at core valuation: The two key value drivers are: 1. Cash flow growth: B’s cash flow growth trumps A. 2. Cost of capital: Lower cost of capital in B (Rd, & ReL are much lower due to leverage), so a much higher value. So B would have a much higher DCF valuation than A assuming they both pay down debt at the same rate. (FACT) Now let’s move on. IRR The key question is which opportunity would result in a higher IRR to equity sponsors, and this depends on the types of financing, or debt/equity mix, and the rates on the various loans. Cash flow assumptions Assume for both A & B, Depreciation/amortization=0, capex, change in WC both=0, and no debt repayments or new issues in both A and B (to make it very simple), then EBITDA=Cashflows. Let’s also assume that we flip the deal over in the first year after closing, so we project over just one year. Now here’s what I’m going to do. Since I don’t have the time to draw out my FCFE for each year, I’ll use a cash flow return on equity that is linear to IRR. (IRR assumes all cash flows are fully reinvested each year…which isn’t very realistic, but cash flow ROE would give us the ability to judge which choice is better from a returns stand point.) For A, in year1 after closing, cash flow(1) =$20M(1.05) The after-debt cash flows augments the shareholder’s equity investment account. Also the initial equity investment from sponsor based on what you said is $20M SH Equity Account(1)= $20M +$20M(1.05) … Cash flow ROE for A= $20M(1+0.05)/[$20M +$20M(1.05)]= 51.21% Cash flow return on equity(A)=51.21% For B, in year1 after closing, cash flow(1) =$20M(1.1) The after-debt cash flows augments the shareholder’s equity investment account. Also the initial equity investment from sponsor based on what you said is $40M SH Equity account= $40M +$20M(1.1) Cash flow ROE for B = $20M(1+0.1)/[($20M +$20M(1.1))] = 52.38% Cash flow return on equity(B)=52.38% Results: All things equal, at exit one year later, B would command a higher valuation, and the IRR (linear to cash-flow ROE) to equity sponsors would also be slightly higher in B (52.38%) than A (52.21%) based on the assumptions above. What does all this mean? The high growth rate in B far out weighs or offsets the huge leverage effects in A…based on our simplistic one year FCFE model, but it works. It should be noted that how both firms pay down debt would have a huge effect on cash flows and can drastically change the outcome of the entire analysis.
wessun - thanks for sharing this and for all your insights along the way. also, you definitely make a critical observation about debt paydown and how it could heavily impact cash flows. for the sake of argument and simplicity, let’s say i assume that the same prepayment terms were available on debt financing for both deals, and assuming that they were in the same industries and had similar working capital and capex commitments (either on an absolute or percentage basis), company B would still generate more free cash flow to pay down debt, thereby reducing the debt component of enterprise value and increasing the value of equity. thus i would still invest in company B. based on my assumptions, does this train of thought make sense?
numi Wrote: ------------------------------------------------------- > It’s true > that the question doesn’t tell you what the exit > multiple for each company might look at, but > because nobody really knows whether the multiple > will contract or expand down the line it’s > generally presumed that you will exit at > the same EV/EBITDA multiple as you entered Valuation multiple is relatively direct mathematical derivation from a discounted div/earnings model. It’s certainly the case that, all else constant, you cannot change multiple without changing growth assumption, and vice versa. (If you do, you’re cheating.) So assuming identical start and end multiples means (unless you change something else, like tax rate) assuming constant growth rates. As you say, we can’t quantify this, but we can say with very, VERY high confidence that B’s growth will slow. Thus the multiple must shrink. BTW an academic paper examine how long outperforming growth lasted – I think this was in the context of IPOs, but it’s not a stretch to broaden the conclusion. Abnormal growth exponentially decays to industry norm, with IIRC more than half of firms having lost their edge by year ~3 and almost none outgrowing beyond year 5.
Dear wessun, You have a critical error in your calculation. You forgot that innitial invesment in Company B is $40MM not $20. Thus: Cash flow ROE for B = $20M(1+0.1)/[($40M +$20M(1.1))] = 35% Investment in Company A is better. It is pretty apparent based on Leverage! Based on your analysis, the ROI is sooooo close that it would be impossible to do it in your head, which defeats the purpose of this excercise. Kide, CFA
DarienHacker Wrote: ------------------------------------------------------- > numi Wrote: > -------------------------------------------------- > ----- > > It’s true > > that the question doesn’t tell you what the > exit > > multiple for each company might look at, but > > because nobody really knows whether the > multiple > > will contract or expand down the line it’s > > generally presumed that you will exit at > > the same EV/EBITDA multiple as you entered > > Valuation multiple is relatively direct > mathematical derivation from a discounted > div/earnings model. It’s certainly the case that, > all else constant, you cannot change multiple > without changing growth assumption, and vice > versa. (If you do, you’re cheating.) So assuming > identical start and end multiples means (unless > you change something else, like tax rate) assuming > constant growth rates. Interesting ideas, but the point of the question was to determine the exit valuation at 5 years to the *equity sponsor*. This kind of valuation receives a completely different treatment than what you’re suggesting, which is entry valuation from the point of view of a minority stakeholder. The reason that EV/EBITDA is used here is because the sponsor is trying to understand what types of returns it will receive on its initial infusion of equity, i.e. IRR. So as far as the sponsor is concerned, acquisition and exit of an entire company is calculated on the basis of EV/EBITDA and allows you to determine the value of each component of the capital structure. Dividend discount model is really not an appropriate metric to use here as you must know if you are on the transactions side (you did say you were in banking right?), as what we are really trying to figure out here is the equity value at entry and the equity value at exit. So, all things considered, the key metrics of concern here is EBITDA (given) and debt paydown (unknown as per the question) at the time of exit, and applying the exit multiple gives you your enterprise value, from which you can back out the debt and get your exit equity value, which is what the sponsor really cares about. I see what you’re saying in that growth rates could make a difference on firm valuation to whoever buys the company after the sponsor exits, but that really doesn’t matter to the sponsor. What the sponsor really cares about here is how much it has grown its initial equity investment over that five-year duration, and that’s how it figures out whether or not it’s a good investment opportunity. > As you say, we can’t quantify this, but we can say > with very, VERY high confidence that B’s growth > will slow. Thus the multiple must shrink. OK, but remember that the exit multiple of concern to us is the one that is meaningful to the equity sponsor (or management team assuming their interests are aligned, which is generally the case with PE investments), so how the company performs after the time of exit really isn’t relevant. Plus, you can’t assume that company A’s growth rate will necessarily decrease (or increase for that matter). > BTW an academic paper examine how long > outperforming growth lasted – I think this was in > the context of IPOs, but it’s not a stretch to > broaden the conclusion. Abnormal growth > exponentially decays to industry norm, with IIRC > more than half of firms having lost their edge by > year ~3 and almost none outgrowing beyond year 5. Interesting, but not particularly useful to the exit valuation from the perspective of the equity sponsor
Thanks Kide, Good observation! My mistake…ouch …ouch…ouch! I entered it wrongly …I apologize to the board. But the correct way to judge competing opportunities is to use the IRR function on the FCFE streams in excel, but I used the cash flow ROE because they are relatively linear. And the purpose of the question is not really to arrive at the “correct” answer but to test the candidates understanding of valuation drivers, leverage and capital structure.
Agreed
Kide, It’s sad… I wish I could go back and edit my post, but the darn thing won’t let me… A is the better choice! PERIOD…NUFF SAID! You’re right Kide!
After ONE year yes, it’s firm A. That’s because compounding growth rates haven’t had a chance to work their magic. Over five years, they have, thus making firm B the better choice over the five year period. So Kide and Wessum - you’re 1/2 right on this question. But I believe it is safe to assume a five year period based on the fact the original question states a 5 year growth period for revenues.
Strikeshank, Run the model. Grow both cash flows by the respective growth. By year 5 assume that each company is sold at respective multiple. Disount these cashflows by the same cost of capital (although Company B will be higher) and then divide it by innitial investment. You will see that it does not make a difference. The compounded growth is important, but you are paying twice more for the same cash flow that will grow only 5% more per year. With compounded growth, (based on Einstein’s law of 72) it will take over 14 yeard to double with 5% of additional growth.
We can’t make cost of debt assumptions in order to come up with a reasonable WACC assumption to discount the cash flows. How high is firm A’s cost of debt given its much higher leverage (4:1) vs. firm b’s modest (2:1)? Despite this, I agree that using EBITDA as a cash flow proxy is reasonable; however, i stand by the statement that given the potential for bankruptcy due to higher leverage etc, that Firm A’s cost of capital could be higher than b’s. That is plausible. You are right it takes much longer for firm B to double its ebitda (14 years as you say) but with ending ebitda values of $25.5mln and $32.2mln for firm A and firm B respectively what additional value has been created due to the multiples? Firm A has added $5.5mln*5 or $27mln in equity. Firm B - $73mln. Why is firm b’s so much higher. Because for every additional dollar of ebitda, it returns 6. And that they have a growth rate double that of firm a, over even 5 years it makes a substantial difference. Simply using the final equity value of both investments ($47mln vs. $113mln) respectively dividing by the initial equity injection of $20mln and $40mln respecively yeilds a result in firm B’s favour. An annualized growth rate of 19% vs. 23%.