26. Valuation 101: How Do You Value a Company?

What is a company "worth"?  We are tackling this question in a multi-part series, starting with valuation 101.  We walk through the three primary methods of valuation: the discounted cash flow model ("DCF"), public comparables, and precedent transaction/acquisition comparables analysis....and explore how they fit together on what's called a Football Field.  Also, we explore the meaning behind the jargon you hear about all the time ---Iike EPS and P/E ratios --- but might not fully understand!  

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Transcript

 Hi, everyone. Welcome back to the Wall Street Skinny with Kristen and Jen. I'm Kristen and hi, Jen. Hi, Kristen. How are you? Doing good. How are you? I'm good. Uh, last night was a, a dark time in our house because I know we don't typically tend to talk about anything other than  the real housewives on our catch ups, but I'm actually going to talk about football for a second.

So my husband was brand new. Oh! fan. I was gonna. Yeah, exactly. So like he doesn't choose to be a Jets fan. I don't think anyone chooses to be a Jets fan, but for whatever reason he was just born into it. My sister in law, so Elizabeth's fiance is also a Jets fan. He happened to be at the game too. He went to the game.

Oh my God. He was at the game.  I mean. I was putting the kids to bed and I came back down. I was like, how's it going babe? Because you know, we watched hard knocks, we got mm-hmm. , you know, and I actually like hard knocks. , did you ever watch that show? I've seen that, no. It's basically they follow a team through their preseason.

Mm-hmm.  And I think the first season they ever did was the Jets. And it was like when we were dating or had just gotten engaged and,  I was a Patriots fan  my  husband then fiancé, was a Jets fan, so like, it's a miracle we ever even got together in the first place.  but so, I don't really care about football anymore as a mom of two little boys.

The idea of  these poor men being sent out, , for our entertainment to like, concuss themselves and get injured, I have a hard time watching it ever since I had kids and become much more sensitive.  But yeah, he's like, this is why I do fantasy football.

It's an emotional hedge because I can never actually  count on the Jets doing anything or winning anything or anything ever going right for them. So at least I have the emotional hedge of fantasy football to like get me through the season. Yeah. John was laughing. He was like, poor Murph can't catch up.

So by the way, so Elizabeth's fiance, his name is. John Murphy. And there's too many Johns in our family. So we just call him Murph. Although apparently he wants, now we know my John to complicate things. But so Murph is How dare he ask to be called by his first name? Doesn't he know that's not going to get him very far in the family?

So he, I mean, again, he's  been like a diehard Jets fan and John was just like, poor guy can't catch a break. I mean, he's like a Jets fan. And then I forget what his football team is, but they don't do well. I think it's like a Mets. I don't know. You mean baseball team. Yeah. Oh, yeah. I mean, you can tell that I, I follow teams closely.

Christian is Jets Mets. Like, I think if you, if you were going to go with one, you know, historically losing team, you just got to go with them all. Like, you can't, you can't. Although, as Bostonians, I mean, like we used to be, it was like the Red Sox. Sucked. There was like a curse,  it was the curse of the bambino and the Patriots sucked.

And then all of a sudden in 2002, we came back. Yeah, I don't started, I don't we're gonna make any friends talking about how Boston was a bad sports town. They were in the entire century.  Well, we won't get into that. so the reason I was talking about the jets, because I was kind of on this theme of gambling and one of the comments that we oftentimes get from people who maybe don't really understand the financial services industry so well is, Oh, it's just a bunch of people gambling with other people's money.

And, , I think that's such a lazy criticism of the industry. , but listen. It is not untrue to some extent. And the reason I was thinking about this is  over the weekend, this Bloomberg article came out.  And you guys remember what happened with GameStop and a lot of the meme stocks , in previous years.

And again,  that movie that they're making about the GameStop saga is coming out soon. I started seeing a bunch of ads for it and I'm really excited for you. Or maybe it's a series. I don't know. series are always better. I know. I much, I much prefer series to movies. I never sit down to watch a movie, yet I'll somehow sit down and watch six hours of, okay, by the way, you turned me on to Summer House, and it is my greatest regret.

I've gotten nothing done over the past week because every time I have a... Spare second. I turn on Summer House and I'm catching up from like 2019. By the way, sorry, you know what, and I just have to like tell anyone who actually does watch it. I messaged Jen when the Lindsay Curl breakup happened and I was like, Oh my God, they broke up.

She's like, wait, they were together. Yeah. I hadn't gotten to that point yet, but it's funny because now it's like people who didn't watch Game of Thrones when it. First out and then the red wedding happened and everyone at work was like, and everyone who didn't watch the show was like, wait, what, what You know?

And so I feel like I'm that person who's catching up on summer house and I'm not like, well, I know where this is going. And  Carl and Lindsay have like gotten together briefly and then broken up. So, you know, knowing that they ended up getting engaged, I'm like, well, I got to keep watching. I got to find out what happened.

So I can see it all fall apart, which is terrible. Uh, I like Lindsay though. I feel bad for her. Well, I feel bad because it's, there's such, it's like a mean girl click in the house. It's starting to materialize. Part of the show where it's starting to materialize. And so I just always, yeah, I always tend to empathize with anyone who was ganged up on.

And no one would be friends with us. So we had to eat lunch alone in the stairwells. True story. We'll get to that at another point in time. It's funny because I like summer house because unlike a lot of the other Bravo shows and maybe this is what it deteriorates into that you've kind of foreshadowed for me.

But at least up till now, it's actually been a bunch of people who seem to legitimately be friends having fun together, which I like watching. Like I like watching. That was the magic. Not just being like, these are random strangers in this manufactured situation who now fight each other all the time.

Well that was the magic of Vanderpump, the early days. It was a legitimate group of friends, who then, like again, I don't know how they tend to pick people who have just like crazy

I think they actually like know how to find that, but it was, it was a genuine group of friends. And then as the show progressed, it started to become like, okay, this person has been hired right to come into the group. And it's sort of like, uh, yeah. So then it's just, it's not as genuine. It's like, Oh yeah, my friend who I'm going to introduce you to on the housewives, but you were cast and we know how this works.

Yeah, exactly. I actually watched a video about the casting process for Vanderpump Rules. It's funny you said that. And they legitimately were just interviewing the bartenders and they got through like three minutes of a conversation with, I don't know if it was Stassi or Tom Sandoval or whatever, who was explaining the relationships of everyone at the bar and like who had dated whom.

And the casting director was like, we're done. Like, we don't need to, like, we found him. This was easy. like the easiest casting of all time because he was like, you can't even write this stuff. Right. And that was all the stuff that had happened before then the show. Yeah. but anyways, so back to our topic for today.

Um. So, I had read this article in Bloomberg over the weekend,  about, , a company called VinFast, V I N F A S T. And I've pulled up the article here, , trust me, this isn't me, like, quoting it by memory. , but the headline was, VinFast's 504 percent Rally Burns Traders Playing Greater Fool Theory.

And so, basically, this was the story of people who had, , been speculating on this, uh,  so it says in episodes strikingly similar to those in the wildest moments of the early pandemic. Think GameStop and AMC Entertainment. Investors are frantically bidding up obscure stocks only to then watch them crash spectacularly.

The very latest example, VinFast Auto Limited, an unprofitable electric vehicle maker that at the zenith of a four week trading frenzy, had a market value greater than McDonald's. And four times that of General Motors, 80 percent in the eight days since.  So I mean, just a wild ride with some of these things and so much of the price action being driven by retail investors, by things like we talk about these Reddit boards and activist investors outside of  the traditional asset manager realm.

But reading this article made me realize that one thing we haven't. So the first thing we haven't sat down to talk about on this podcast yet is equity valuations. Okay. And if you want to play in these crazy gambling circles of buying and selling stocks, , or if you're interested in one of the more traditional financial services roles that we've been talking about on this show, private equity, venture capital, which we're going to get to next week, equity, long, short hedge funds, asset managers, anyone who is.

It's managing money and putting it to work. If you want to play in the equity markets, you need to start with the process of fundamental valuation before you can get to any of this other crazy stuff. Before you can get to, you know, DeMarc signals and all that fun stuff that everyone likes to talk about that sounds so sexy,  again, we really need to have a foundation in fundamental valuation. And so who better to talk to us about that than our very own Kristen, who literally taught this for 13 years, so knows it like the back of her hand.

And this is something that I'm not very familiar with, and I honestly think that there are a lot of people out there  Who are too afraid to admit that they don't know what the difference is between like EPS and PE ratio and what do all these things stand for? What do they mean? How do we calculate them?

How can we be smart about it? So we wanted to start from the beginning. We've talked about corporate valuations from a 10, 000 foot view of looking at financial statements, building a discounted cash flow model.  But I think we really want to talk about,  what,  big institutional players in the equity markets are looking at when they start with fundamental analysis.

 So I'm going to let you take it away. Sure. All right. 

When you do these analyses, what you are solving for. A lot of the times, If you are a equity long short investor, if you are a mutual fund, if you are a investment bank, helping a company go public, you're solving for what is the implied fair share price. What is the equity value per share, right?

That is the company's stock price. 

 And  Jen, it's actually so funny you started off talking about football because we literally like, we never talk about football, but I think in order to paint an accurate picture of how fundamental analysis works, we actually have to start with something called the.

Football fields, um, which I'll get into more detail. Yeah. And we did, I did a video on this a while back.  But look here, this is what you need to know to start. So a football field is a combination of three primary analyses. So you have the public comparables analysis, Precedent Transaction Analysis, which people will sometimes call like Acquisition Comparables, um or Transaction Comps, and then the Discounted Cash Flow Analysis or the DCF. Ah, got it. My favorite. Yes. Yeah. 

There's a difference when you're talking about investors,  because there's different sort of reasons and ways of measuring.  Is something a quote unquote good investment.

And so, you have these, , private equity firms who, when they're looking at an investment, they're deciding is something a good investment for them based on  affordability, right? Can I buy something and sell it in say five years and get a 20 percent IRR? You have, , companies like  we use the Amazon Whole Foods example where you have.

Amazon going out and saying, Hey, I want to buy a company, but the purpose of it is you are, you know, trying to sort of fill potentially a operational hole in your business, or you want to take market share. So, you are going to value a company, but your decision to buy or not buy again, is not necessarily dictated by like the pure fundamentals itself, because by the way, I deal can look in the, of strategic acquisition space, quote unquote, a creative and still be 

terrible from a valuation standpoint. So what is it when we talk valuation,  what are people looking at? And I guess, you know, if you're sort of bucketing,  who are the people that are  looking at sort of the fundamentals, I mean, look, everybody is. You know, you have your investors like the equity long short investors or mutual funds, you know, they're  trying to quote unquote seek alpha, if you will, and then you also potentially have your dumb money like me or anyone who  doesn't have their  complicated systems.

 But you can still understand  the fundamentals. And so that's what we're going to try to get into. From a fundamental valuation 101 standpoint,  how do you value a business?  So let me take a step back. So I do think it's important to know that we have these different valuation methodologies.

Um, doing evaluation. It is a process of looking at these different valuation methodologies and trying to  triangulate in on a value so that three primary methodologies that we have. Are the discounted cash flow analysis that is  the most academic, like you go to business school. That is what you're going to learn.

And then we have comps. And there's two types of comps analysis. You have,  public comparables analysis and acquisition comparables analysis.  , you can throw a leverage buyout,  analysis on a football field.  That's a little more rare, There is this concept with an LBO analysis where you are calculating the floor valuation. So in other words, what is the lowest price that this would drop to before a private equity firm says, Hey, this thing is super cheap.

I can lever it up, hold it for five years and get a 20 percent IRR. So theoretically, if the share price drops to that point, a private equity firm is going to be like, Hmm, this is a great buy for me now. And so you can throw that on there. It's not saying like, this is what it's worth, but it's saying that at some point this price should be the floor. But it's usually the two types of comps.

So public comparables based on where the company is currently trading, and then acquisition comparables, precedent transactions, what deals were done in the space where you had companies being bought by entire firms.  So public comparables analysis is saying, Hey, I'm going to look at companies that are similar to the company I want to buy and look at how the market is valuing those companies.

That again, are publicly traded. Then I use what the market is implying those are worth, and I value the company in question. The other type of analysis is you look at actual companies that have been sold the whole company, right? They're not, maybe they're not, maybe they weren't even public to begin with, but you're looking at how much did a buyer pay for the company as a whole? You sometimes will want to distinguish between those strategic buyers.

So the Amazon's buying, say, Whole Foods and the financial buyers, say the KKR is buying Dunkin Donuts. I don't, I don't know if it was KKR that bought Dunkin Donuts, but  The difference is you oftentimes see that strategic buyers are willing to pay more. Sure. So,  you'll probably see that the multiples paid for past deals are higher. Then the multiples where the company is currently trading and why is that? Well, there's two reasons. Number one, when a, strategic buyer buys a company, they expect to get synergies. They don't need two CFOs.

There's gonna be some layoffs. They don't need two marketing departments. There's gonna be some layoffs. Whereas the financial buyers.  Now they're probably going to also have a lot of layoffs and all that kind of stuff. But they also are usually not willing to pay as much. You also have what's called this control premium, , which is, someone knocks on your door and says, Hey, I'd like to buy your company.

And it's like, well, we don't want to sell, you're going to have to pay us to buy control. So,  for that reason,  your precedent transactions are typically going to show higher multiples than past deals. Got it. 

Mm-hmm. in both of those cases, is you are going to use metrics like we use in, again, I'm going to go back to real estate because like I said, so many people , tend to be familiar with real estate. So Jen, obviously as a real estate agent, , when you are trying to come up with what you think a house is quote unquote worth, you're probably going to look at comps.

You're going to look at the house down the street and say, Hey, this just sold in the last few months and it was sold for this price per square foot. Your house is bigger. Your house is whatever. Feet? 2, 000 square feet. 2, 000 square feet bigger. So, your house, , I'm going to take that price per square foot and apply it to that larger square footage.

So I can figure out what the value of your house is by looking at how much people are willing to pay per square foot for this other home. With companies, you do the same thing, only it's not price per square foot. It is a PE ratio, right? Price to earnings. And we'll get into what that is in a second. It is a enterprise value to EBITDA ratio.

It is a, in the sort of, bank space. It is price to book. There's these different ratios and the ratio itself will depend on the industry that you are talking about, but it's the same idea, You're looking at where are these other companies either trading in the market? Or what have they been sold for?

And you take that ratio and apply it to whatever statistic it is that you care about for your company itself.  To create the most apples to apples comparison, you said is going to be dictated by a number of things. It's going to be dictated by the industry.

It's going to be dictated by probably the availability of comps, right? Yeah. Well, I mean, this is where sometimes people will get creative as to who the comps And,  again, I'm sure you've seen this in the real estate business where it's like, Hey, I have this house that looks nothing like any other house, but let me stretch a little bit and kind of see what I think, , is a potential.

I mean, you have crazy situations where, again, using real estate as an analogy, you can't use a condo or a townhouse as a comparison for a single family home. Yeah. But if you build a single family home in a condo and townhouse development, guess what? You're going to certainly inform your process of thinking about that by using those inputs.

I imagine similarly, if you're trying to create a company that looks like all these other things, even though for some reason they're not comps, it has to inform your thinking about it. Yeah, exactly. we actually, I was working on a deal, this is a true story, in the financial sponsors group when I was at Morgan Stanley. And we were working with a client and they were, like an online education space, ironically enough.

And the client wanted to use Google as a comp for themselves. And we were like, well, we can include that for you, but that's not what investors are probably going to be using. Like, we can say whatever you want and come up with a valuation. Kristen, I really think Google's a good comp for the Wall Street skinny if anyone wants to invest.

I know, seriously.  Different people can have different,  views on who the appropriate cops are. Another example I like to use is,  when Shake Shack went public. So actually this is means I have to take a few steps back because it goes to the whole research analyst community.

And so when a company goes public,  for the first time. And the bankers have to figure out what is this company worth? , they basically tap on the research analysts at each firm. And, so the research analysts have to  put together, it's called an initiating coverage report. When they are initiating coverage on a company for the first time, usually it was when that company goes public.

And there were four firms,  for Shake Shack and  it was like JP Morgan and Barclays and I forget who else, but. You looked at the list of comps and, you know, three of them had Chipotle,  like companies you would expect. The crazy part is that, one of the research analysts said, who am I including in my comp set, they included Lululemon,  Under Armour, Nike, and,  and again, they had like Chipotle.

And the argument for it was they wanted companies that had strong brand value, high growth, yeah. And  kind of also tangentially ironic as well, SoulCycle at one point was considering going public. think they actually did. And,  Shake Shack was considered a really good comp for them.

And so you might say to yourself, but wait a second, how, right? They sell such different things. It's like a burger at a, but they're very almost like city centric, right? In the sense you can charge really high prices in a Manhattan, you know, you can charge 76 for a Primo seat at SoulCycle and you can charge, I don't even know what Shake Shack hamburgers cost in they started in Madison Park. Yeah, yeah, yeah. Now they're in every single airport. But  the pricing, , is gonna look different. So it sort of had like the New York pricing and then it had like the everywhere else pricing.

so the point though is that like when you're talking about COPS, right, , it's,  it's an art and a science.  Got it. Yeah, so okay. You've walked us through like the 10, 000 foot view of public comps and acquisition comps. Now, can you speak to that third methodology we use on our football field, the discounted cash flow model?

Because for me, that is the trickiest one to understand. Yeah, the DCF is, there's a lot that goes into it, but like with all of these analyses, what we're ultimately trying to figure out is what we think a fair stock price is, right? What is a fair value of the equity per share, the share price? Got it.

and so the way that you get there,  with a DCF, , just again, for people who may not know what a DCF is, it is the discounted cashflow analysis. So in order to put this together,  you have to look at what the company has done in the past, and then you have to get assumptions about what's going to happen in the future.

Sometimes a company might give you projections. You might then say, well, I don't know if I'm going to trust management projections. I'm going to come up with my own projections. Maybe if this is a public company, equity research has some projections. Maybe a certain bank that you like has some projections because you're working at a specific bank and whatever.

You're going to come up with your own set of assumptions. And so. The, the, the most important part is figuring out the projections. And there's actually two parts to that, because there is  the projection period, because,  you can project out five years, 10 years, 15 years, theoretically, you need to project the company out until it achieves what's called steady state.

Meaning it is  growing,  a little bit more than inflation, but less than GDP, right? It's sort of steady. And so the hard part with the DCF is you need to figure out when exactly is that steady state. By the way, how does the company's sales change over time? How does the company's margins change over time?

How does the company's capex change over time? What is their working capital? Like there's all these things that go into it. There are so many assumptions. So you project out those cash flows and then you need to discount those cash flows back by some discount rate. And by the way, that discount rate, we had a whole conversation where we talked for 20 minutes about choosing the beta to go into the discount rate, which is like, I mean, it's a good little part.

So there's a lot of  thought and work that goes into coming up with your DCF. , I mean, look, it could be as lazy as you want it to be, but  if you want a really good DCF, I mean, you can spend a lot of time coming up with the assumptions. By the way, little tweaks in those assumptions can have a massive change on the valuation, which is why, it's sort of a joke I've heard people say before, which is like, you can kind of manipulate the DCF to say the company's worth whatever you want it to be.

Mm hmm. Which is terrible, right?  That's why sometimes with the DCF, it's a very important thing you need to include in your valuation analysis, but comps are oftentimes relied upon as well. 

With a DCF, so you've projected out your cash flows, you discounted those cash flows back, that gets you to the value of the firm. That's the value of the house. And that's enterprise value or equity value? That's enterprise value. Enterprise value. And from there, you subtract out the debt, you subtract out what's owed to everyone else.

If the company has non controlling interest, if the company has preferred, subtract that out. If the company has a pile of cash you added in, that gets you the value of the equity. Got it. And then you put it on a per share basis. Poof. We got it. implied fair share price  so if you've done your discounted cash flow analysis and it spits out this share price, and that share price is higher than the share price at which the company is currently trading in the market, the inference that you've made if you trust your model is that that company is cheap, right, relative to the model, and it's theoretically a buy.

Right. Yes. Although, so here's, here's a few other just little caveats. So number one, a lot of times when you're looking at. What is the value of the business,  on a per share basis, you're probably going to have it be a range. Like it's not going to be, Oh, the share price is 94. 27, right? It's going to be 90 to 100.

So you're going to come up with a range based on your sensitivity analysis. Oh, yeah. Your sensitivities, your inputs.  So yes, theoretically, maybe that is a buy. But you also need to know a little bit more about like, the story.

I mean, I guess this would be like the reverse, if you find out that the company is higher, like trading higher, The DCF, the DCF spits out a low share price and it's trading higher in the market you need to then go to see what's going on in the news, right? Was there some,  announcement of a potential merger? Because if there was, the company's share price is going to start trading based on the expectation of an acquisition.

Because I always like to make the point sometimes, yes, you have found an amazing buying opportunity more often than not, there could be an opportunity for improvement in your assumptions, you know, so  ,  as  Brian said in the episode last week, he's like, you are trying to find potential buying opportunities but  I don't necessarily want to feel like I am smarter than the markets,  is there a possibility?

Yes. Is there a greater possibility that there is an opportunity for proven in your assumption? Is there something you're missing? Probably. So  I just like to make that generally speaking, when you're running these analyses. It's spitting out something close  to the current market price.

Probably. Probably. But that's, that's again, the DCF. Remember how, and I can't overstate this enough, how sensitive the DCF is to minor tweaks in your assumptions. A minor tweak to your assumption for the beta, a minor tweak to your assumption for the perpetuity growth rate, a minor tweak to your exit multiple.

 These are things. That are tiny tweaks that can drastically shift what your valuation is. , the thing that's nice about the DCF.

Is it forces you to say, when is this company going to get profitable? Back to that company you were talking about. What was it called? Like Fast Car or something? Uh, VinFast. VinFast. So VinFast, right?  If you were to do a DCF versus like, I'm just going to buy it because everyone says I should be buying it.

Right, right, right. If you actually look at.  The research community, what are their projections? When are they going to become profitable? And again, I know nothing about this company. Yeah, she's probably never, if you get into this article, right, 99 percent of the company is owned by one guy who got, you know, one of these blank checks for the company, you know, like a reader or something, you know, it's absurd.

So that's where you need to do a little bit more digging. Like, is this Elon Musk, who is that one guy? Or is this like random Joe Schmoe, who also was the one who's like pumping up this.  Company on the Reddit community. 

 So it's not just looking at  the company itself, right? Who are the investors? You know, you can actually look up who the top public shareholders are. Is it, I mean, Fidelity, right? Is it Wellington? Is it strong institutional investors who are going to be holding onto this, who believe in this, who , are not going to be selling  even if the share price goes down, they're in it for the long haul.

Or is it a whole bunch of people who, and I love how Anish said this in the past, is it people who are all buying it and then now like, shit, I have to get out. Like, you're their exit liquidity. You are literally, it's like the, the tulip. Remember the tulip, um. craze. The Dutch tulip. Yeah, yeah.

Yes, yes. Which is it, ?  Is there a real person who's  running this business, or do they actually have potential profitability?  It is worth noting that not all businesses are going to be so black and white. and I feel like, 

 If you look at say a biotech company,  sometimes there is these other methods. I think it's called like first Chicago method  is one of the names the, the idea is  it's almost like. Not an option or decision tree, but you have multiple possible outcomes.

If you have a company and there is a,  startup and they're probably not public, but maybe they are, , they're trying to get a patent through the FDA approval process.  And it's not just, what are my projections? It is, is this company going to get approved? And is it going to be a home run?

And I'm going to be earning tons of money for the next 14 years. Or is this going to. Cause cancer or cause some terrible side effects, and it has to get pulled. I mean, those are two very different things. So you would like probability weight, the various outcomes. again, it's using the same tools of  the DCF or whatever, but you're, you need to  add in this element of what are the possibilities, because it's not as simple as.

These are my projections, it is if this happens then this is the value, if this happens then we have a different value. It's high volatility. Mm hmm.  So we've covered the discounted cash flow model and that's how we arrive at one potential estimation of what the share price should be, very, very heavily caveated.

Yeah. I also feel like I have a pretty good grasp on  what the huge differences are between that and the two types of comps analyses that you touched on earlier. Can we now  go back to comps though and get into multiples?

Because Kristen, everyone always talks about these multiples. And I think, I mean, I know I certainly don't, I think most people don't actually know the difference between PE ratios and EPS and price to book and what that all means and what do we use them for? Like what different circumstances do we use them in?

Yeah. I mean, look, so in any kind of comps analysis, you're going to have to find an apples to apples. Comparison, right? To compare different companies to one another. So, I mean, just like you have different houses that are like massively different sizes. So the house example, right? You need to figure out what is the dollars per square foot for a particular group of houses in some sector.

You're going to do the same thing for companies in a particular industry. And the choice of what multiple to use, right, is, is super important. That makes sense. The choice of are you looking at the past? Are you looking at the future? Are you looking just next 12 months? Are you looking next calendar year? Are you looking two calendar years out? , that's going to be an important thing because It always has to be apples to apples. Now what is a P E ratio? So the P E ratio basically just represents how much a investor is willing to pay for 1 of expected earnings. So if, and I think, let me look up Apple because Apple's my favorite, 

 So it looks like Apple's P. E. ratio today is 30. This is according to my random search results, so don't come after me if that's wrong. that is in the ballpark of where it is. But so that means that an investor like you and me is willing to pay for every 1 of expected earnings that Apple generates,  next year, we'll pay 30 for that, which is actually kind of crazy because  there is something called the peg.

Oh, what's that? PEG stands for price to growth. So you take the PE ratio and you divide it by the expected growth of a company. In what units? Percentage. Okay. Multiplied by a hundred. So, , the growth is usually looking at  what is the five year expected EPS,  growth rate.

And so usually research will have an assumption for that. Because by the way, , I don't know how you're going to continue to grow,  at a huge amount being the size that Apple is, although they've, you know.

Surprised us. I, I like never wanted to buy Apple. This is like in 2010. Cause I'm like, they can't get bigger. This is why I'm a terrible investor. You're talking to the girl who thought the iPhone would be a bust. So you're in good company. . So here, here, let me just go through the numbers. Let's say I'll just use the numbers.  10 percent growth and I'll show you why. Okay. So with the pig ratio, you say, what is the PE ratio over what is the next five year expected growth rate?

So in Apple's case, their PE is 30, their expected growth is 10%. We take 30 over 10, that gives us three. Peg ratio theory says a company with a peg ratio of one is fairly valued. So Apple's three times that. A peg ratio greater than one is expensive. A peg ratio less than one is inexpensive. So for a company like Apple.

 If your peg ratio is three that means that like, technically do investors expect 30 percent annualized growth over the next five years? Maybe.  That seems high, but I mean, maybe, you never know.  By the way, remember this is EPS growth and so you can manipulate EPS growth.

It's earnings over shares. You can manipulate.  Earning some share growth by buying back shares. They have a lot of cash. They could potentially just buy a ton of shares and then they have the market value is what it is over fewer shares. So again, when you have in the denominator, something that is going to be influenced by shares.

Sure. It's possible.  And again,  I feel like never bet against Apple.

, so we've covered PE ratio. 

You also could have companies that are not profitable. So like, let's take a look at like a company in the tech space. 

Actually Pinterest.  P E ratio probably doesn't make sense because  they're not making money. If you're looking at valuing Pinterest,  and you are looking at all of their multiples on a next 12 month basis, you're not going to take that and multiply it by Pinterest last 12 months of earnings.

Right? It needs to be apples to apples. So you could say, hey, this company should trade on a PE basis. Great. Guess what? Pinterest has negative earnings. P. E. doesn't work. Now what?

So yeah, so then you would need to look at something else. 

, so, your other,  potential multiples are... And by the way, P. E., just because a company, by the way, is profitable, doesn't mean that a sector is going to trade on P. E. Some companies and some sectors actually trade off of what's called enterprise value to EBITDA. Like, that is the main metric you would look at.

Um, but P. E. is a very, very common one. Why is that? Why, like. Speak a little bit more to just aside from profitability, what goes into your decision to use different metrics, like It's kind of just a standard. Versus price to earnings. It's just like You need to understand what the standard is. This is what's done in retail.

For the most This is what's done in Yeah. I mean, so here's, so  for example, if you have an industry That there's been a lot of leverage buyouts in the past. So some companies have a ton of leverage and other companies have very little leverage. It might not make sense to look at P. E. It might make more sense to look at enterprise value to EBITDA.

Just because that added element of the debt might like skew things a little bit. , so, so again, if , you have an industry , that has had a lot of these leveraged buyouts, a lot of companies that have been recently now taken public, like post sponsor buyout, again, it might make more sense.

So, but,  how do you figure out what is the right multiple? I mean, it's you sort of get a sense of it just by being in that industry, right? If you're in the industry, it's like, okay, this industry trades on P, okay, this industry back to  banks, because they trade on something very different, which is called price to book value of equity.

Very different. Okay, so what's that? So in the bank world,  banks have to, what's called, mark their assets and liabilities to market every quarter. So on their balance sheet, they have the book value of equity. On their balance sheet, what does the equity value say it's worth? So in the bank space, what you look at is what is the market value of the equity over the book value of the equity.

That's it. In other industries, you don't care what the book value of equity is because it's not marked to market. and liabilities to mark to market. And they're not marked to market. So that book value of equity,  you know, if you, I mean, this gets into accounting, like, where does equity come from, from an accounting standpoint?

It's just your prior year equity balance plus Your retained earnings, so plus the net income you earned, minus any dividends you paid, and then  plus any equity that you've issued, so options,  any sort of additional,  equity issuance, minus your buyback. And then there's also stock based compensation thrown in there as well, so, but the point is that it just becomes like this account that kind of just like has shit going into it and going out of it.

But, it doesn't reflect what the market necessarily believes the company is worth. Got it. In the bank space, it's a more... It's much more important, right? Yeah. It's much more it actually speaks to their business model in a way that it wouldn't in other... Yeah. Industries. Yeah. I mean, again, if you have a company that has like a loss, you even could have companies have negative equity.

 That happens. The companies will actually have negative equity on their balance sheet, which is crazy, but , it happens. So,  this is going to get way into the weeds, 

but when a company does do a leverage buyout, there can be this accounting choice that is made. There's something called recap accounting that basically says instead of treating the leverage buyout as a new acquisition, you treat it as what's called the leverage recapitalization. You basically treat it like a giant share buyback.

And so, because you're buying back a ton of equity, you actually can have the equity go negative just because you've chosen this accounting  methodology. Which doesn't mean that they're, I mean, again, it doesn't mean that the business model is any different had they chosen this other, more typical,  accounting choice instead.

What are the other ratios that we should talk about? I mean, so the P. E. ratio is probably the big one people are familiar with, uh, you also have enterprise value to EBITDA. That's another big one, especially for private equity firms. And the reason for that actually is, so when a private equity firm is going to invest in a business, they are going to pile debt on the company.

And the way that people tend to talk about how much debt you can take on is also as a multiple of EBITDA. So for a business, right, if you're buying a company at say 10 times EBITDA, and you know, Hey, I can put in six times EBITDA, you kind of know roughly how much equity you're putting in. If that makes sense.

So it's just an easier way to  keep apples to apples. So you're buying a company for this multiple of EBITDA and you're getting this amount of debt as a multiple of EBITDA.  Is that, is that because that's a metric used by lenders commonly and thinking about how much, okay, how much they'd be willing to lend.

Got it. Yeah, exactly. So when you're, I mean,  we would get private equity firms come to us and say, how much can we borrow? We're thinking of buying this, you know, putting a bid in, there's this auction going on for this company.

They're, you know, the sales process going on. We want to put in a bid. How much can we borrow, and what's the pricing?  We would call up Leverage Finance, and they'd say, yeah, given  current rates, given  the appetite for lenders and what we think we can syndicate the debt at, you can lever this up at like six times EBITDA, it's going to be in this structure, the bank loan is four times EBITDA, the, , bonds at two times EBITDA, maybe you can get an extra, so it's quoted as multiples of EBITDA.

So it's sort of easier to just say apples to apples. That makes sense. So the other reason why you tend to focus on that  metric is private equity firms are buying the whole business.

The P ratio is an equity ratio. Hmm. So when you're looking at the valuation of the whole business, it makes more sense.  I always think about, look, look at the income statement, okay? On the income statement, you have revenues, you have your expenses, your costs of goods sold, your SG& A, and then you get to your EBIT,  add some depreciation and remuneration, that gives you EBITDA.

That is the line, right? EBIT is actually often referred to as the line, because it separates your operations from  the financing. Because what comes below the line, it comes interest. Expense, interest, income, those are financing decisions. So, by the way, the private equity firm is going to come in and they're going to change up that financing.

So, they don't care what's happening to the net income. They care about above the line. So that's the other reason why it's such an important multiple, is that you are looking at the whole business.  Like, we're buying a house, I'm not looking at what is the equity.  The seller's equity that the house, I don't care.

You don't care how much they owe on their current loan. No. You don't care about any of that stuff. Right. It's all getting paid back when you buy it. So, enterprise value to sales, enterprise value to EBIT, enterprise value to EBITDA is like price per square foot in that sense. It's an operational sort of multiple, if you will, whereas the P.

E. ratio is looking at the equity. 

So  we've got our various metrics to play with now. We've got PE ratios, right, price to earnings. We've got EPS, earnings per share. We've got price to book for the financial services industry. We've got EBIT, or rather we've got enterprise value. to EBIT or EBITDA and in the power and natural resources space, there's probably going to be some metric using whatever the units of energy that are sold by the business are.

So price to megawatt hours or whatever it might be. Yep.  Alright, so, for the steps to actually, like, doing this comps analysis, first thing you do is you figure out who are the comps, right?

Because you are going to calculate the P. E. ratio, calculate the enterprise ID, but for all of the comps first. And then you apply it to the company in question. 

So, we've decided, we're looking at Pinterest. So, who are Pinterest comps? You have Snapchat, you have Facebook, you have, I mean, Twitter is now X and it's It's private, but whatever, let's use Snapchat and Facebook, okay?  By the way, most of the times you're probably going to want at least five to six.

So I just want to put that out there, like, you're not going to say, Hey, Snapchat, Snapchat and Facebook and I'm done. No, you're going to at least probably need to do six, possibly more.  But anyway, so you look at all of your different comms.  Now what is the right multiple? Let's pretend,  that Pinterest does not have negative earnings that we're doing PE.

So I would say, what is Snapchat's stock price over what is their expected earnings? I get a PE of 40. What is Facebook's,  share price over their expected earnings? Get a P E ratio of 30, whatever it is. I look at all those. I say,  so based on those multiples, the fair P E ratio is call it 30 to 40.

I then take 30 to 40 and I multiply it by Pinterest EPS. Now, Pinterest has negative EPS, so if I wanted to do it for,  Enterprise ID EBITDA, it's actually a little bit harder, because I would now have to, remember, we've talked in past how the equity value that you see in,  Yahoo Finance and CapIQ does not calculate the.

 Equity value the right way. They are not including diluted shares.  I would have to go through every single company. I'd have to look at their 10K. I'd have to look at all this random crap and I'd have to come up with, what is the enterprise value? How do I do that? Share price times the number of diluted shares outstanding.

Have to look at what are their options? What are their RSUs? What, so I have to do that whole process. So I calculate the enterprise value. Which, remember, equity value plus net debt.  I do it for all of the companies, and then I divide it by EBITDA, EBIT sales,  whatever the financial performance metric is that I care about.

And then, now I say, great, I want to figure out what is Pinterest worth. Well, it becomes a little more tricky because when I take that multiple, I'm making up a number. 10 to 15. And I say, great, 10 to 15 times Pinterest EBITDA. Well, that's going to get me an implied enterprise value. I have to now convert that enterprise value into a price per share.

How do I do that? I subtract the net debt and divide it by the shares. That's how I come up with my implied share price. So got it. Yeah. That is the comps analysis. By the way, people hate comps because the process of going through and  calculating the correct equity value and enterprise value for all these different companies, and then sometimes too, if you're looking at the enterprise value over, call it the last 12 months of EBIT, EBITDA,  which is not the norm.

You're usually going to use expected numbers, but sometimes people like to know what was  going on in the past. You have to like scrub their financials to see where's their non recurring items. It just, it becomes like a mess. It's such a time consuming process. People literally hate comps.

Everyone loves modeling. People hate comps. Um, because it's a DCFs. Well, DCFs, three statement models, leveraged buyout models, M& A models. People just like building the Excel models. The comps process just becomes a very tedious. Process. Because so much of it , is manual, right? It's manual, yeah. And different companies...

A lot applied to different segments of each thing. Yeah. Cause you have to go through the filings of every company and you're doing it for 6, 10, 15 companies. Every company's filings look different, they report differently, by the way.  Sometimes you need both the 10Q and the 10K if you're calculating the last 12 months instead.

So like if the latest filing was a Q, guess what? The latest Q only reports a quarter of sales, a quarter of,  EBIT, whatever it is. And by the way, actually, this is also annoying too, is  EBITDA is not a gap term. EBIT and EBITDA are not gap terms. You have to figure out what the EBIT and EBITDA are.

And different companies,  will have totally different ideas about what the EBIT and EBITDA are.  It's not a GAAP term. It is a proxy for operating income and operating cash flow that financial practitioners use, but there's subjectivity even in that. So there's just a lot that goes into it.

That's why nobody likes comps, because there's too much random crap. Oh, I get it. I get it. Okay. So now that we've covered all the different types of analyses, how do we actually put them together? Yeah, so now it's time to actually build that football field that we talked about earlier.

and so as a reminder, like, what is a football field? It is a triangulation. Of our three analyses.  And, and possibly actually we sometimes include the leverage buyout, right? That's that sort of floor valuation that I touched on earlier. And how do we actually build this thing out and what does it look like?

 The,  the bars in the football field, usually what happens is you on the,  y axis, you have the different methodologies.  And so you'll probably start with like a 52 week high low. You then will have public comps, precedent transactions, DCF. You'll probably throw a DCF with synergies on as well, which basically says I'm going to take the DCF, I'm going to try to come up with what the synergies would be worth in a hypothetical deal independently, and how much extra per share would that add to my DCF if I had Like a hypothetical merger with someone else?

Yeah. Yeah. Okay. I didn't know you were going to see this. In,   let's say,  you're sitting there trying to value Whole Foods, right. Back in the Whole Foods example,  the bankers were probably putting on the football field.

What is Whole Foods worth as a standalone company based on the public comms precedent transactions, DCF, right? So that's that intrinsic valuation. And then if Amazon buys Whole Foods, what are the synergies that Amazon is going to achieve by buying Whole Foods? And you run a DCF on that and you add that, so that, that would be a sort of additional line on the football field.

For a strategic acquisition, would you do that line for a financial acquisition though? No. No, no, no. I mean like you, you could because by the way there could be in a,  if there's an auction process going on, you could have strategic buyers and financial buyers, so you might want to understand the different strategic buyers who are, yeah, yeah, yeah, how they're looking at it, so what they might be willing to, to do.

 But, so sorry, so yeah, so you have your public comps. Acquisition comms, and I keep saying, sorry, acquisition comms to me, precedent transactions, same thing. Uh, synergies, and then the leverage buyout floor would be, , at the end.  The Y axis, right, is the different valuation methodologies and the X axis is the share price.

And so you'll have bars because you'll have like a high and a low for each of those methodologies. So you basically have these bars that kind of stack up against each other. All else being equal, would the comps analysis probably be the ceiling with the DCF somewhere in between, assuming you didn't make any crazy assumptions?   So, so you're exactly right.  And actually one last thing, I mean like the DCF, you could have multiple bars on the DCF. You could have the DCF with the management projections, you could have DCF with consensus research projections.

Like you can have different bars for the DCF even out of itself because those assumptions  can swing the valuation obviously a lot. So you might You might have different bars for the DCF as well, and then you look at it and poof, that's what the company is worth. But that's more of the sort of banker standpoint.

Um, I don't know. And again, this is something I'd have to ask like an equity law and short guy. I mean, I don't know if they're putting together these football fields. I don't think so. Well, I think that's kind of, so the, the segue here is I think in our next episode in this call it mini series is, um, is now that we understand the process of.

Fundamental valuation from an investment banker's standpoint at looking at a company,  what's the next step then for somebody who's trading these things in the secondary market from a much shorter investment horizon, who's not looking at, you know, again, buying the whole company or whatever the different analyses that we went through, but someone who's like, Hey, is this stock rich or cheap?

Right? Well, they're using the exact same tools. There's then the investment thesis part of it, right? So then there's that added element of you want to really understand each company.  And then you also want to understand  well, what are the risks again?

Who are the investors? What could cause? What's this valuation to change? How long am I a holder for? What's going to drive me to potentially sell? Like there's even more you have to think about, but the ability to put together these analyses, and I think even like building a DCF, the act of actually building it can really teach you a lot about the company.

I mean, this is something that I saw, feel like I talk about liquidity too much, but I saw someone be like  why is there even bankers anymore? Like, why is there Excel and PowerPoint monkeys? The sort of junior analyst and, he replied something like, well, MD has got to come from somewhere, but it's true.

Right. I mean, here's the thing, the act of putting together a model. Forces you to think about how is this company's profitability going to change over time? What are the key assumptions I am making that is driving this valuation? And can I sell chat TV to you? Oh, what is this company worth?

Sure. And it's going to spit something out, but  you're not understanding the individual assumptions, right? You're not getting to know this thing, like the back of your hand, the way that you will by building the model, the act of building the model is teaching you about the company.

And I think that that's what people sometimes miss is that.  Building the model and like understanding what's going into it, understanding what's driving the valuation is so important to then come up with what you think this company is actually. You know? I love that. That's great. And I also, I guess the last thing I'll just say is  you know, I use the analogy when I'm teaching Excel that so much of it is, it's like the reps. I mean, it's like training at the gym.  And this is something with AI that I'm so curious about is that , sure, again, AI can build the model, but  you as the investor, they like don't understand.

You're not going to know all the assumptions that go into it.  That's what I feel like people are missing is that the act of  actually building a model is teaching you so much that you're not, and again, maybe that's fine because it becomes more signals and like all this other stuff, but I don't know.

I'm curious, like how things change because I, I sort of wonder , are people ever going to stop building models? My, my instinct is no.  Whether or not people. Stop building models, I think, is, less the question than, it's very clear in all these models that  there is so much human input that needs to happen on the assumptions.

Right. So,  yeah, maybe in some distant future, you are just telling AI what the inputs are, ? And it's building the model then for you and, you know, that's what human oversight gets limited to at some point, but like you said, if you don't understand where you're coming up with those inputs.

What the model spits out then has no meaning, right? Yeah, I guess it's just sort of like, to me, it's the difference between having a teacher give you a printout, right? You're like, great, here's my slides. Versus you're taking notes and you're writing it down. The act of actually writing shit is how you learn it.

 Like, to me, sure, AI can do it, but I think you kind of lose the connection with what those assumptions are, what they even mean, when you don't have something you've written. I mean, you're preaching to the choir, I'm such a big believer , of, again, learning by doing.

Yeah.    It's also part of a general cultural shift that people no longer are interested in becoming masters of a craft. Right? Everyone just wants to know enough to get by and then it's on to the next thing. That's true.  It's very clear that you take a lot of pride in, in the mastery that you built  of building these models. And I think that that's, that's worth something, 

 The act of building something is what actually solidifies your understanding a lot of the times. Whether it's about a particular company, whether it's about the accounting specifics, you know, whatever it is. That's why you have labs in, in science classes, right? You can sit all day long and write down equations, but until you actually go and touch something and run an experiment  and see it play out.

Yeah. Yeah, yeah, yeah. You know, it's, it's a very different type of mastery of the material. Yeah. So, , anyways, we, we really hope you guys enjoyed, , this segment. Again, Kristen, I learned so much. I'm so incredibly grateful for you. I'm excited for, I think, future iterations of this to come where we talk to people who are now putting this analysis into practice and combining it with more,  Market signals based strategies with quant strategies like we've talked about in the past on the credit and fixed income side mostly Yeah, , so, stay tuned.

This is part one of many  so again, thank you guys always so much for listening,  and we really appreciate all of you who have given us written reviews. If you haven't yet, um, please leave us a five star written review on your podcast platform  of choice, whether it be Apple podcast, Spotify, wherever you guys are listening. We are so grateful for those reviews. And again, those really help us reach more people.  Our reach is continuing to expand every single day. We're so grateful for you guys. And we want to get  our word and our mission and all of this great information out there in the world.

So thank you so much. And, uh we'll see you next time. Bye. Thanks guys.