Three core methods of valuations | The value definitons and multiples from earlier in the chapter are applied in several ways to best approach how much an entity could be worth.
There are three major methods utilized to approach this value:
- Comparable company analysis
- Precedent transactions analysis
- Discounted cash flow analysis
Each of these three methods is based on wide-ranging variables and could be considered quite subjective.
However, each method approaches value from a very different perspective. So we can have relatively strong support of value from a financial perspective if all there methods fall along a similar valuation range.
Note that there is often considered a fourth method based on a lever-aged buyout analysis.
Three Core Methods of Valuations
1. Comparable company analysis
The comparable company analysis comapers our company with companies that are similiar in size, product, and geography.
The comparable company analysis utilizes multiples as a measure of comparison. If the peers’ multiples are consistenly hingher than the multiples of the company we are valuing, it could mean that our comapny is unvervalued.
Conversely, if the peers’ multiple are consistently lower than the multiples of the company we are valuing, it could mean that our company is overvalued. The comparable company analysis has one major advantage over the other three:
a. it is the most current of all three analyses. Is gives a market perspective
The comparable company analysis is based on the most recent stock prices and financials of the company. However, the comparable company analysis has the following drawbacks.
b. It may be difficult to find companies to compare
If the company has a unique bussiness model, is in a very ‘niche’ industry, or is not the size of a public company, it may be difficult to find the right peer group.
c. The markets may be undervalued or overvalued
We could be in a market environment in which the entire industry is overvalued or unvervalued. If so, our analysis will be flawed.
2. Precedent transactions analysis
The precendent transactions analysis assesses relative value by looking at multiples of historical transactions.
The value of our company is relative to the price other have paid for similiar companies. So, if we look for other companies, similiar to ours, that have been avquired, we can compare their purchase multiples to assess approximate value of our business.
3. Discounted cash flow analysis
This discounted cash flow [DCF] analysis is known as the most ‘technical’ of the three major methods, as it is based on the company’s cash flows.
The discounted cash flow takes the company’s projected unleverd free cash flow [UFCF] and discounts it back to present value [PV].
We typically project the company’s cash flows out five to seven years. We then create a terminal value, which is the value of the business from the last projected year into perpetuity.
The enterprise value of the business is the sum of the PV of all the projected cash flows and the PV of the terminal value.
DCF Enterprise value = Present Value [PV] of UFCF Year 1 + … + PV of UFCF Year n+PV of Terminal value. The DFC analysis has this major advantage over the other three:
a. Is this the most technical
It is based on the company’s cash flows from model projections, as opposed to the comparable company analysis, for example, which is mainly driven by market data.
The analysis also hase several disadvantages:
b. Terminal value
Although the firs projected years are based on modeled cash flows, the terminal value accounts for a very significant portion of the overall valuation. That terminal value is based on a multiple or a perpetuity.
c. Model projections
The model projections could be inaccurate; they could be overstated or understated, depending on what is driving the projections.
d. Discount rate
The discount rate may be difficult to estimate. We will go through standard techniques, but these standards do not apply in all situations. Again, as all three valuation methodologies have significant drawbacks, they do have strengths. ~
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