When valuing a company, there are three main valuation methods that are being used by financial professionals:
The first method is DCF analysis, the second method is comparable company analysis, and the third one is precedent transactions.
These are the commonly used methods of valuation used in investment banking, equity research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO), and most other areas of finance.
When valuing a business or asset, there are three different methods or approaches a practitioner can use.
The Cost Approach looks at what is going to costs to rebuild or replace an asset. The cost approach method is useful especially in valuing real estate, such as commercial property, new construction, or special use properties.
Financial practitioners do not typically use this method to value a company.
The second one is the Market Approach, which is a form of relative valuation and frequently used in finance to value a company.
It includes Comparable Analysis and Precedent Transactions.
Finally, the third one which is discounted cash flow (DCF) Approach is a form of intrinsic valuation and is the well-detailed and thorough approach to valuation modeling. I will explain better the methods used in the Market and DCF approaches below.
Method 1: Comparable Analysis (“Comps”)
Comparable company analysis (which is also known as “trading multiples” or “peer group analysis” or “equity comps” or “public market multiples”) is a relative valuation method in which you compare the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios.
Multiples of EBITDA are the most common method of valuation.
The comparable Analysis “comps” valuation method provides a value that is observable for the business, based on the current of other comparable companies.
Comps are the most widely used approach in valuing a business because they are easy to calculate and always current.
A comparable company analysis is a process that is used to calculate the value of a company using the metrics of other businesses that are of similar size and also in the same industry.
Comparable company analysis operates under the general assumption companies that are similar will have similar valuation multiples, such as EV/EBITDA.
Financial analysts will put together a list of available statistics for the companies being reviewed and evaluate the valuation multiples in order to compare them.
Comparable company analysis begins with establishing a peer group that comprises similar companies of similar size in the same industry.
Investors are then able to analyze and contrast a particular company to its competitors on a relative basis. This information can be used to find out a company’s enterprise value (EV) and to calculate other ratios used to analyze a company to those in its peer group.
The logic behind this is if company X trades at a 10-times P/E ratio, and company Y has earnings of $6.50 per share, company Y’s stock must be worth $65.00 per share (assuming the companies have similar characteristics).
Method 2: Precedent Transactions
Precedent transactions analysis is also another form of relative valuation where you compare the company in question to other businesses that have been sold or acquired recently in the same industry.
These transaction values include; the take-over premium included in the price for which the companies are acquired were acquired.
The values illustrate the en bloc value of a business.
They are useful for M&A transactions but can easily become stale-dated and no longer reflective of the current market as time passes.
Precedent transaction analysis is a method of valuation in which the price paid to acquire similar companies in the past is considered an indicator of a company’s value.
It creates an estimate of what a share of stock would be worth in the case of an acquisition.
They are less commonly used than Comps or market trading multiples.
Method 3: DCF Analysis
Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the business’ unleveraged free cash flow into the future and discounts it back to the present at the firm’s Weighted Average Cost of Capital (WACC).
A DCF analysis is done by building a financial model in Excel and it takes an extensive amount of detail and analysis.
It is the most detailed of the three approaches to valuing a business and requires the most estimates and assumptions.
However, it takes effort to prepare a DCF model and it also often results in the most accurate valuation.
A DCF model allows the analyst to forecast value based on different scenarios and even perform a sensitivity analysis.
For big businesses, the DCF value is mostly a sum-of-the-parts analysis, where different business units are modeled individually and added up together.
Discounted cash flow (DCF) is a method of valuation used to estimate the value of an investment based on the future cash flows that are expected.
DCF analysis tries to find out the value of an investment today, based on projections of how much money it will yield in the future.
This is applicable to the decisions of investors in companies or securities, such as company acquisition or buying a stock, and for business owners and managers looking to make decisions on capital budgeting or operating expenditures.
The cost approach, which is not only used in corporate finance, looks at what it actually costs or would cost to rebuild the business.
This approach does not take into consideration any value creation or cash flow generation and only examines things through the lens of “cost = value.”
Another valuation method that professionals also use is for a company is called the ability to pay analysis.
This approach looks at the maximum price an acquirer can pay for a business while still hitting some target.
For example, if a private equity firm needs to hit a hurdle rate of 40%, what is the maximum price it can pay for the business?
If the company could not continue to operate, then a liquidation value will be calculated and estimated based on breaking up and selling the company’s assets.
This value is usually discounted as it assumes the assets will be sold as fast as possible to any available buyer.