Steps

1. Calculated the average or mean of the multiples – see Precedent Transaction Comps or Public Trading Comps
2. Apply discount or premium to your multiple – see Precedent Transaction Comps or Public Trading Comps
3. Apply premium to your target

Assuming the mean revenue multiple is 1x, and the target had $20m in revenue, then the value of the target is $20m.
Assuming the mean EBITDA multiple is 7x, and the target had $5m in EBITDA, the value would be $35m.
So based on these two multiples, the value of the company would range from $20m to $35m.

Timing

Be sure to the timing of your multiples and your targets numbers are correct. For example, using forward looking multiples and LTM revenue will give you misleading numbers.

Variation within the range

There would be more variation as you consider where the target’s multiples should fall within the range of the compset. If it has a higher EBITDA margin than it’s peers, then it deserves a higher EBITDA multiple.

Again this is where the art of valuation comes in to play.

The example below, taken from the Oracle/Autonomy deck shows recent precedent transactions in the enterprise software space.

The list would be shorter and more varied than the trading multiples compset.

Premium

With most acquisitions, there is a premium paid for the target. There is value to controlling the company rather than just investing in the target. There is potential for operational synergies (top-line growth, decreased overhead, decreased financial risk, funding cost etc.)
That premium is included in the price of the acquisition and hence baked into the M&A multiple, so you would need to discount the M&A multiple to get to a fair trading multiple. I’ve seen discounts ranging from 15% to 50%.

After coming up with the the multiples, you apply them to your target.

This post will give an example of public comparables methodology. A public compset is a select set of publicly traded companies where price metrics and operating metrics are laid out in a table for comparison with the target company. The example below is a quick compset I threw together of internet companies with Apple and RIMM thrown in for comparison.

What companies to include

Ideally, there are direct competitors and pure plays, meaning they only focus on that one product/service. You can also include companies that offer similar services. In our example compset below, most are internet/tech companies. But there is a sub-segment of pure internet companies if you remove Apple and RIMM.
You can also segment the list based on size or other outliers.
In my experience, the ideal list size is 7-10 companies.

Price Metrics

A typical compset will first include the stock price, equity value, and total enterprise value. The stock price is pulled directly from any stock quote service; the others are derived from the stock price. Both equity value and enterprise value are also easily pulled from most stock quote.

Multiples

The common multipes included in a compset are the Revenue Multiple, EBITDA Multiple, and P/E Multiple. These are a simple calculation of the total enterprise value devided by the relevant operating metric. There are several variations on the timing of the metrics including current year, next year, and last twelve months (LTM).
You can also include more industry specific metrics. Real Estate would look at rental rates while a product company would focus on gross margin.

Industry Operating Metrics

Key operating metrics are also included so that the company can be compared to the industry as a whole to make the case for a higher or lower valuation.
They typical items included are:
* Cash and Debt – Leverage makes a big difference in how a company approaches financial decisions. Less debt means more cash flow available to the shareholders, therefore a high price.
* Revenue – Size does matter. A billion dollar company has scale and other effiencies that a hundred million dollar company won’t have.
* Revenue Growth – The higher the growth rate, the higher the price.
* Margin (Gross, EBITDA) – Margin is usually tied to the business model. A services company’s margin is different from that of a product company. Higher margin means more income which translates to a higher price.

Art vs Science

Like other aspects of valuation, putting together the numbers is a science. They are driven by logic and calcuations and is straight forward.
The art is in how you tell the story of the target.
If you are the buyer, you want to use the numbers to drive a lower price. Using the multiples and metrics above, you would develop reasoning to support your lower price. For example, a smaller company compared to the industry typically has lower multiples. You can segement your compset and see if there is a distinct difference in the multiples. If the company has lower margins compared to the industry, the multiples should be lower. Use the numbers to prove your case.

Valuation of private businesses

Public valuations don’t translate to private businesses. So, you apply a discount of varying degrees to the multiple before valuing the business. There are two common reasons to discount the multiple, size and liquidity. Liquidity is straight forward. As a private company, you can’t just buy and sell the shares- you’re locked up for a long period and that lack of liquidity typically translates to a discount of 15%-25%. Size and economies of scale is the other reason for discounting. I’ve seen it applied anywhere from 5% to 50%. Again this is part of the art of valuation and making the numbers work for you.

Real World Example

Check out these public comparables slides developed by Qatalyst Partners for the sale of Autonomy to HP.
Autonomy/HP Deck 1 - Slides 10 and 11
Autonomy/HP Deck 2 - Slide 8
Both are great decks, but the three slides noted above are specifically a public compset.

As always, you can download the sample public comparables excel file.

In the current sample financial model, deprecation and CapEx are not forecasted to change. However as the business grows, additional equipment is needed.
In the new model, we CapEx spending in Years 5,6 and 8.

CapEx affect on financial statements

This will have implications for all three financial statements.

Income Statement: Depreciation expense will increase due to additional assets to depreciate
Balance Sheet: Long Term Assets and related line items will increase because of the purchase of assets
Cash Flow Statement: Cash Flow From Investing will change to accounting for the cash used to purchase the assets

While all of these changes will have trickle down effects that you need to be area of
Income statement: Increased depreciation expense will affect net income
Balance Sheet: Decreased cash because cash out the door to purchase

With CapEx purchases come depreciation. There are many plays on depreciation that we won’t get into. We’ll keep it simple with straight line depreciation for all assets.

The CapEx numbers for Years 1-4 are fixed because those are historical, so don’t modify those or it won’t match the other versions of the model.

The downloadable excel model below is the depreciation schedule for the CapEx purchases above. You can change the timing and amount of CapEx and see how that changes depreciation.  You can also change the useful life of each purchase.

We have some pretty complex calculations to build out the depreciation schedule. You can keep yours very simple but just using formulas without all the if/then statement.

Integrate CapEx and Depreciation schedule into financial model

The overall formula for capex and depreciation in relation to assets is: Beginning value + CapEx – depreciation = Ending Value

These old values and formulas in the main financial model need to be replaced by links to these new line items.  The only two that need to be linked are PPE, Gross and Depreciation Expense. The other three line items, CapEx, Acc. Dep, and PPE, Net, are already linked properly in the main financial model and don’t need to be modified.

Remember to check your balance sheet to make sure it balances.

** Interview Tip: This concept is a very common investment banking interview question. I’ve heard it phrased in many different ways, but the concept is the same: Talk me through the  financial statement effects of an asset purchase.

In the balance sheet assumptions section of the model, see below, we calculate each metric and then make assumptions about the forecast values.

Days Sales Outstanding (DSO)

DSO is a measure of how long it takes a company to collect on it’s accounts receivable. The higher the DSO, the slower the collecting – that’s a bad thing. The faster the company can collect, the more options for the company such as investing in more inventory to turn into sales.

The formula for DSO is (Accounts Receivable / Credit Sales ) * 365

In our model, DSO was too high, so we’ve brought it down to more reasonable levels.

Days Payable Outstanding (DPO)

DPO is a measure of how long it takes the company to pay it’s accounts payable. It’s the opposite of DSO – the longer it takes the company to pay, the more opportunity the company can use the money to generate sales.

The formula for DPO is (Accounts Payable / COGS ) * 365

In our model, the DPO historical average was 92 days. However, most creditors only like to give 30 days of credit, so we’ll adjust DPO downwards.

Days Sales Inventory (DSI)

DSI is a measure of how long it takes for a company’s inventory to turn into sales. The shorter the better because the company carries less inventory and hence less cash is tied up.

The formula for DSI is (Inventory / COGS ) * 365

Inventory Turns

A related metric to DSI is inventory turns. Inventory turns is a measure of how many times you sell your inventory per period. In our model, the inventory turns is 7.7 times per year. In general, the higher the number the better.

The formula for inventory turns is COGS / average inventory

Cash Conversion Cycle

DSO, DPO, and DSI taken together is the cash conversion cycle for a company. DSI measures how long it takes for money invested in inventory to turn into sales, DSO measures how long it takes to bring cash in from the sales, and DPO measures how long it takes to pay for the inventory.

Analysis and Forecasting the Balance Sheet

Analysis of these metrics is straight forward. Calculate and compare to industry comps to make sure they are within reason.

To forecast, calculate historicals and use the average as a starting point. From that starting point, you can adjust based on what you think the company will do. For instance, if a young company has very high DSO historically, you might want to forecast the DSO will come down over time as the company gets a grip on its financials and processes.

We do not forecast inventory turns, because DSI does that for us. It is just a metric to keep an eye on.

The formula for the forecast periods is the reverse of the formula you used to calculate the metric. See the model for examples.

It is important to understand what each metric means and does. Play with the model by changing some of the assumptions and see what each does to the ending cash balance. If you increase DSI, meaning it takes longer to turn inventory in to sales, then the cash balance will decrease.

Prepaid Expenses and Accrued Expenses are two other balance sheet items we need to forecast in our model. They are fairly straight forward in that we just use a percent of relevant line items. In the model, the prepaid and accrued expenses were too high historically, so we just lowered what they would in the future.

** Modeling Tip: Check your balance sheet to make sure it still balances. If you built your cash flow statement properly, then adding in these new assumptions and forecast should not require any work on the cash flow statement and it should still balance.

** Interview Tip: Using historicals to forecast is the easy answer. Assumptions with good rationale behind them are the skills, knowledege, and thoroughness interviewers want.

** All of these metrics can be done on a monthly, quarterly or annual basis depending your what your model periods are.

A circular reference is when a cell refers to itself directly or indirectly.

Are circular references bad?

In most cases, a circular reference should and can be avoided with some planning. However, in a complex financial, I found it easier to just use circular references in certain areas.

Circular References in Financial Models

Circular references are used to help calculate cash balances. Let’s walk through two typical cases.

Interest

The cash sitting in the bank generates interest. The interest income is taxed and lowers the net income. More cash -> more interest -> more tax -> lowers net income -> effects cash.

See the example below. To determine the amount of interst, we use an average of the forecasted beginning and ending cash balances. It’s not fair to use just the beginning or the ending cash balances to calculate interest because over the time period that balance will change.

Think about it another way, if you have $100 in the bank at the beginning of the month and $200 at the end earning 2% a month, what should the interst earned be? $2 of $4? Neither, it should be something in the middle because your cash blance grew during the month on its way to $200. So for simplicity of forecasting, we just average the beginning and the end and say $3 ($100+$200)/2 * 2%. It’s not perfect, but it’s a step in the right direction.

Debt

The amount of cash shoftfall determines the borrowing needs which determines the interest expense which determines the amount of debt.

How to enable circular reference

You have to check “Enable Iterative Calculation” in Excel Options -> Formulas -> “Enable iterative calcuation”
Maximum iterations should be 100 (default).

What happens when your circular reference errors out?

This happens pretty often as you’re developing your model because if you pass an error into a circular reference, by definition it won’t be able to solve the equation.

See the example below. All the forumlas are correct, but somewhere in the process there was a mistake made and it threw off all the calculations.

You can resolve this with a commonly used “jumpstart”. All bankers use this, so it’s not some random hack. Jumpstart is a two-part formula you stick into cell where there an error would throw off the ciruclar reference.
The first part is to define a cell called jumpstart and the value will be TRUE or FALSE.
The second part is to change a row of your formulas to incorporate jumpstart. In the example below, we’ve incorporate into the average cash calculation by changing it to =IF(Jumpstart,1,(C42+C40)/2) instead of =(C27+C25)/2

This means if Jumpstart is TRUE, insert 1, otherwise calculate the average. By inserting the 1, it allows the calculations to work again…by giving the calculation a “jumpstart” with a value instead of an error.

To see Jumpstart in action
1. Change the FALSE next to “See Error” to TRUE and then back to FALSE. This simulates as if an error was made and then corrected.
2. Change the FALSE next to “Jumpstart” to TRUE, this will fix the errors by making the average cash $1.00. Change back to FALSE (to turn off Jumpstart) and it will revert back to normal calculations.

** Modeling Tip – If/Else is a powerful forumla. Learn it and use it.

The balance sheet itself is not the problem, it is usually the cash flow statement that introduces the error.

Here are some tips to make sure your cash flow statement is correct to ensure you calculate the correct ending cash balance.

For a working model, start with the basic financial model.

General

Make sure you rebuild the historical cash flow statement with formulas, that’s the only way to ensure you’ve accounted for all numbers and everything will flow going forward.

All line items on the balance sheet must be used in the cash flow statement.

Cash Flow from Operations

Net Income – pulled directly from the income statement

Depreciation – depreciation is a non-cash expense, so it needs to be backed out of the cash flow; pulled directly from the income statement.

Assets

The Excel formula for an asset line item from the balance sheet on the cash flow statement is the previous period less the current period.

In our model, we need to calculate the year 3 cash flow for accounts receivable (AR) line item. The formula would be AR for year 2 minus year 3 on the balance sheet.

The verbal explanation is if the asset on the balance sheet increases from the previous year, then it was a use of cash. If the asset decreases, then it is a source of cash.

If the AR increased, it means the company did not collect from its customers so there was a use of cash. If the company collected cash and lowered the AP, then it is a source of cash.

Liabilities

Liabilities is the opposite of assets. The Excel formula for accounts payable (AP) on the cash flow is year 3 minus year 2 AP line item on the balance sheet.

The verbal explaination also the opposite that of an assets. If the liability increases, then it is a source of cash. If the liability decreases, then it is a use of cash. To continue the AP example, if the liability decreased, then the company used cash to pay down the AP. And the inverse, if the company did not pay off some account payables, the AP will increase and the company saved some cash.

Cash Flow from Investing

See Assets and Liabilities above for calculations and formulas.

Cash Flow from Financing

See Assets and Liabilities above for calculations and formulas.

Calculating the Ending Cash Balance

Beginning cash plus the change in cash equals the ending cash balance. The balance sheet cash line item should link to the ending cash balance from the cash flow statement. This will create a circular reference, but that’s ok - read why circular references are a necessary part of financial models.

For the historicals, the ending cash balance from the cash flow statement should equal the cash on the balance sheet. If they match up, then your model is working perfectly. If not, something went wrong.

Leave your questions or comments below and I’ll do my best to answer.

Rebuild the historicals

To forecast the income statement, you have to understand the historicals. So start by rebuilding the financial statements.  This means taking the given values and adding formulas where necessary.

If you want to give it a shot (highly recommended), you can download the values only version and rebuild the financial statements by adding in formulas for all three financial statements.

Add assumptions

Assumptions for an income statement are things like growth rates or changes in revenues and expenses based on certain factors and judgements. Each line item can have a related assumption line item.

There are many variations on how to calculation assumptions, but three are pretty common.

We build forward looking assumptions based on historical performance.  If COGS was at 70% of revenue for the past three years, it really should not deviate far from the 70%. Looking forward however, the COGS assumption can change, but there should be an explanation for the change – volume discounts, new products, new pricing etc.

I like to include assumptions in a group at the bottom of the related financial statement.  In this case, the assumptions related to the income statement are between the end of the income statement and the beginning of the balance sheet. This makes it easier to keep make changes to assumptions without having to jump all over the place.

Financial Modeling Tip: Stick with widely accepted color schemes for modeling – blue for variables, plugs, or assumptions, black for formulas, and red for “beware of changing” such as links to other workbooks.

Revenue assumption: Average growth over the past three years = 26%, but 26% growth year after year for the next 6 years sounds unrealistic, so I manually entered the growth rates.

COGS assumption: COGS is usually calculated as a % of revenue. The average over the past four years was 69.4%. I used the average for years 5-7, but lowered to 65% for years 8-10, assuming that with increased sales, there would be some volume discount.

Salaries assumption: Because this is a small business with few employees, I just plugged some salary growth assumptions based on when I felt the store could use an extra hand.

Rent/Utilities assumption: It was assumed the rent would increase a small amount after 6 years.  Utilities increased only slightly.

Depreciation assumption: Deprecation was kept flat for simplicity sake. Deprecation will be covered in later posts.

Taxes assumption:  Taxes are 35% and only taken when the company is profitable. Net Operating Loss will be covered in later posts.

Financial Modeling Tip: After creating all the assumptions, make sure your assumptions are reasonable and defendable. Just because it was true historically, it doesn’t mean it will always be true.  Revenue growth is a good example. Revenue growth is usually very high for a young company, but as they mature, revenue growth will slow.

Incorporate your assumptions

To incorporate the forward looking assumptions is simple. The formula is essentially the inverse of the assumption forumla. For example, historical revenue growth was calculated as growth over the previous period and the forward looking forecast would be the inverse – growth over the pervious period.

Test your assumptions

Modify each assumption line item and check to make sure the math works. In most cases, you can keep an eye on the EBITDA and net income lines, if they move in the direction and magnitude as you expected, then most likely things are fine.

Check to make sure your balance sheet is still in balance.

Thanks it for the income statement. Download the working excel model and play around with the assumptions. What would you change?

Below is a sample balance sheet.  It is part of a larger working financial model.

To keep it simple, the example includes basic line items including:

In the context of this site, financial modeling will be about forecasting the future performance of a company and related transactions using a standard three financial statement model in Excel.