Major Valuation Methods

monkeysama's picture
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I've heard of the "four valuation methods" but I haven't been able to find out what those are. Anyone have a link?

Types of Valuation Methods

When someone refers to four valuation methods, usually they are referring to a discounted cash flow, trading comparables, precedent transactions, and a leverage buyout analysis. We discuss these methods below.

However, User @Race shared an alternative way of looking at it:

Race:

There are multiple Methods but 3 main approaches to Business Valuations

  1. Income Approach - DCF Method + All discounted Cash and Earnings models, including debt assumptions
  2. Market Approach - Transactions Multiples Method + Guideline Comparables Method
  3. Asset Approach - Replacement Methods + All related liquidation Models

The M&M theory says regardless of Debt added to the business the EV is still the same. In Leverage model, use the Ke for Equity CF, while in a Debt Free model use WACC, the PV should always be the same. LBO's, leverage leases, etc don't increase the EV, (Maybe the ROE).

This is only a theory and I have never gotten the same answer using Ke & WACC, regardless of the type of debt, Project Finance, LBO, Leverage Lease, Bank loan, etc. This is due to a static WACC in my Debt free model.

Discounted Cash Flow Analysis

A Discounted Cash Flow or DCF is one of the most important methods used to value a company. A DCF is carried out by estimating the total value of all future cash flows (both inflowing and outflowing), and then discounting them (usually using Weighted Average Cost of Capital - WACC) to find a present value of that cash.

The aim of a discounted cash flow is to estimate the total amount of cash you will receive from an investment, and if this value is higher than the cost of the investment, it is usually worth doing.

Put simply: A DCF looks at the intrinsic value of the business by finding the future cash flows and discounting them back to today.

You can read more about the steps of a DCF here.

Leveraged Buyout Analysis

LBO stands for Leveraged Buyout and refers to the purchase of a company while using mainly debt to finance the transaction. Leveraged Buyouts are usually done by private equity firms and rose to prominence in the 1980s.

User @bankbank" shared:

The "LBO method" isn't intended to give you the "intrinsic" value of the firm. All the LBO method does is tell you what valuation an LBO buyer could pay for the company to achieve a target equity return (usually around 20%+) assuming a leveraged capital structure. This valuation should be lower than a DCF because your discount rate (includes 20%+ "cost of equity") is higher. To calculate the LBO method value, all you do is build an LBO model with an equity IRR output and then goal seek the purchase price to target a 20% IRR.

Also, capital structure will affect TEV to some degree (that's why there's an "optimal capital structure" that minimizes the firm's WACC...minimizing WACC increases TEV). Modigliani Miller (M&M) makes some assumptions (e.g., companies don't pay tax) that aren't realistic.

You can learn more about LBOs in the video below.

Precedent Transaction Analysis

The precedent transaction method has you look at a group of companies similar to the one you are valuing, see what kind of prices they have been bought and sold for, and apply a similar valuation method to the target company.

In this example - we take three recent transactions and find the average Transaction Value / EBITDA. Then we take that average multiple and multiply it by the target companies EBITDA value to find an implied transaction value for the company.

In this case you are multiplying the EBITDA of $850 by the average industry TV/ EBITDA multiple of 11.1x to get an estimated transaction value of ~$9,741.

Comparable Analysis

The most common way to value a company is through the use of comparable analysis. This method attempts to find a group of companies which are comparable to the target company and to work out a valuation based on what they are worth.

The idea is to look for companies in the same sector and with similar financial statistics (Price to Earnings, Book Value, Free Cash Flow, EBITDA etc) and then assume that the companies should be priced relatively similarly. Comparable analyses are frequently referred to as "comps."

The process for how to do a comparable analysis is as follows:

  • Find a selection of comparable companies
  • Choose and calculate the appropriate multiples for each company
  • Find the average value of each multiple across the comparable companies
  • Use the multiples to determine a valuation for the target company

Comparable analysis can either be done using trading multiples (how the company operates) on public comparable companies or transaction multiples (at what relative level was the company bought or sold) on precedent transactions.

Some of the most commonly used multiples are:

  • Price to Earnings
  • Enterprise Value / EBITDA
  • Return on Equity
  • Return on Assets
  • Price to Book Value

Read More About Valuation on WSO

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Comments (45)

Jan 19, 2011

DCF, trading comps, Acquisition comps, and LBO

"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger

Jan 19, 2011

What's the difference between trading comps and acquisition comps? I think that's where I'm stuck.

Jan 19, 2011

Trading comps: market data on where peers trade, the metrics change as market prices change
Precedent comps (aka, acquisition comps, transaction comps): shows at what valuation other peers were acquired in the past, the metrics do not change as the data is all historical

Jan 19, 2011

To conclude. The first shows the market's valuation of the peer group. The second shows the actual buyers' valuation.

Jan 19, 2011

C'mon man... thats one of the most basic interview questions... check out the guides. You have more points than I do and don't know the 4 valuation methods?

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Jan 19, 2011

I don't know as much about equity research as I would like. That's why I asked.

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Jan 19, 2011

What about DCF wacc, DCF APV, RIM and DDM?

Valor is of no service, chance rules all, and the bravest often fall by the hands of cowards. - Tacitus

Dr. Nick Riviera: Hey, don't worry. You don't have to make up stories here. Save that for court!

Jan 19, 2011
El_Mono:

What about DCF wacc, DCF APV, RIM and DDM?

Somebody correct me if I am wrong, but I think DDM is just something they like to teach in school and not really used much in the real world (not IBD at least).

Isn't APV useful for an LBO?

"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger

Jan 20, 2011
nonpog:
El_Mono:

What about DCF wacc, DCF APV, RIM and DDM?

Somebody correct me if I am wrong, but I think DDM is just something they like to teach in school and not really used much in the real world (not IBD at least).

Isn't APV useful for an LBO?

Wrong. DDM is one of the primary valuation methods used in FIG groups.

Jan 19, 2011

I'd say those all fall under the "DCF" umbrella.

What's ironic is there is a Google Banner next to this thread, at least for me, advertising a WallStreetPrep program that teaches you to "build lbo, dcf, m&a, and comps models"

Jan 19, 2011

There are multiple Methods but 3 main approaches to Business Valuations
1. Income Approach - DCF Method + All discounted Cash and Earnings models, including debt assumptions
2. Market Approach - Transactions Multiples Method + Guideline Comparables Method
3. Asset Approach - Replacement Methods + All related liquidation Models

The M&M theory says regardless of Debt added to the business the EV is still the same. In Leverage model, use the Ke for Equity CF, while in a Debt Free model use WACC, the PV should always be the same. LBO's, leverage leases, etc don't increase the EV, (Maybe the ROE).

This is only a theory and I have never gotten the same answer using Ke & WACC, regardless of the type of debt, Project Finance, LBO, Leverage Lease, Bank loan, etc. This is due to a static WACC in my Debt free model.

    • 1
Jan 20, 2011

The "LBO method" isn't intended to give you the "intrinsic" value of the firm. All the LBO method does is tell you what valuation an LBO buyer could pay for the company to achieve a target equity return (usually around 20%+) assuming a leveraged capital structure. This valuation should be lower than a DCF because your discount rate (includes 20%+ "cost of equity") is higher. To calculate the LBO method value, all you do is build an LBO model with an equity IRR output and then goal seek the purchase price to target a 20% IRR.

Also, capital structure will affect TEV to some degree (that's why there's an "optimal capital structure" that minimizes the firm's WACC...minimizing WACC increases TEV). Modigliani Miller (M&M) makes some assumptions (e.g., companies don't pay tax) that aren't realistic.

Race:

There are multiple Methods but 3 main approaches to Business Valuations
1. Income Approach - DCF Method + All discounted Cash and Earnings models, including debt assumptions
2. Market Approach - Transactions Multiples Method + Guideline Comparables Method
3. Asset Approach - Replacement Methods + All related liquidation Models

The M&M theory says regardless of Debt added to the business the EV is still the same. In Leverage model, use the Ke for Equity CF, while in a Debt Free model use WACC, the PV should always be the same. LBO's, leverage leases, etc don't increase the EV, (Maybe the ROE).

This is only a theory and I have never gotten the same answer using Ke & WACC, regardless of the type of debt, Project Finance, LBO, Leverage Lease, Bank loan, etc. This is due to a static WACC in my Debt free model.

    • 2
Jan 20, 2011
bankbank:

The "LBO method" isn't intended to give you the "intrinsic" value of the firm. All the LBO method does is tell you what valuation an LBO buyer could pay for the company to achieve a target equity return (usually around 20%+) assuming a leveraged capital structure. This valuation should be lower than a DCF because your discount rate (includes 20%+ "cost of equity") is higher. To calculate the LBO method value, all you do is build an LBO model with an equity IRR output and then goal seek the purchase price to target a 20% IRR.

Also, capital structure will affect TEV to some degree (that's why there's an "optimal capital structure" that minimizes the firm's WACC...minimizing WACC increases TEV). Modigliani Miller (M&M) makes some assumptions (e.g., companies don't pay tax) that aren't realistic.

Race:

There are multiple Methods but 3 main approaches to Business Valuations
1. Income Approach - DCF Method + All discounted Cash and Earnings models, including debt assumptions
2. Market Approach - Transactions Multiples Method + Guideline Comparables Method
3. Asset Approach - Replacement Methods + All related liquidation Models

The M&M theory says regardless of Debt added to the business the EV is still the same. In Leverage model, use the Ke for Equity CF, while in a Debt Free model use WACC, the PV should always be the same. LBO's, leverage leases, etc don't increase the EV, (Maybe the ROE).

This is only a theory and I have never gotten the same answer using Ke & WACC, regardless of the type of debt, Project Finance, LBO, Leverage Lease, Bank loan, etc. This is due to a static WACC in my Debt free model.

Wouldn't an LBO valuation give you a higher valuation than a DCF? Here is my reasoning, you assume a purchase premium in the purchase price of an lbo, you assume that you can increase the CF's of the company when a PE firm acquires it by making management changes / rolling over other companies / imrpoving ops etc, so the CF's alone will grow at a higher rate than when oing a DCF. I am only a recent grad about to start as an analyst next month, but this is my understanding and was an answer I gave an interviewer and he moved on.

Just would like some clarification.

Jan 20, 2011

[quote=
Wouldn't an LBO valuation give you a higher valuation than a DCF? Here is my reasoning, you assume a purchase premium in the purchase price of an lbo, you assume that you can increase the CF's of the company when a PE firm acquires it by making management changes / rolling over other companies / imrpoving ops etc, so the CF's alone will grow at a higher rate than when oing a DCF. I am only a recent grad about to start as an analyst next month, but this is my understanding and was an answer I gave an interviewer and he moved on.

Just would like some clarification.[/quote]

Thanks for clearing that up bank. Would you be able to comment on if an LBO can ever have a higher valuation than a DCF based on the above thought process? Thanks again.

Best Response
Jan 21, 2011
SHORTmyCDO:

[quote=
Wouldn't an LBO valuation give you a higher valuation than a DCF? Here is my reasoning, you assume a purchase premium in the purchase price of an lbo, you assume that you can increase the CF's of the company when a PE firm acquires it by making management changes / rolling over other companies / imrpoving ops etc, so the CF's alone will grow at a higher rate than when oing a DCF. I am only a recent grad about to start as an analyst next month, but this is my understanding and was an answer I gave an interviewer and he moved on.

Just would like some clarification.

Thanks for clearing that up bank. Would you be able to comment on if an LBO can ever have a higher valuation than a DCF based on the above thought process? Thanks again.[/quote]

I'm going to try and explain this simply, but it would be better explained with some math and modeling... Apologies in advance for being long-winded.

Also, a "financial sponsor" is a financial buyer (a private equity or VC firm, as opposed to a strategic/corporate buyer). So when I mention "financial sponsor" or "sponsor," I am referring to the PE firm doing the LBO.

An LBO valuation is akin to a DCF valuation, except the costs of capital are higher. When bankers talk about the LBO as a valuation method, they are thinking of the "valuation" in terms of the financial sponsor's ability to buy the company and generate a 20%+ IRR (most sponsors/PE firms are targeting ~20% or more). This 20% IRR is sort of the cost of equity financing from the sponsor. Because of this high cost of capital for the LBO'd company (i.e., high discount factor in the PV calculation), the PV of the company is going to be lower. For this reason, when bankers compare the 4 valuation methods (ignoring for now any liquidation/replacement value measure), the LBO is usually going to spit out the lowest valuation.

You are correct when you say that to complete an LBO of a public company, a sponsor will have to pay a premium to the market price. However, an LBO doesn't make sense and a sponsor won't do an LBO (and pay the takeover premium) unless they expect to earn a 20% IRR on the deal. Private equity doesn't price deals based on the public market prices - it prices deal based on the expected IRR. We actually talk about deals like this at my firm...if we presented a 20% IRR deal to our investment committee and the company was more risky than the normal 20% deal we would show the committee, they might say something like "a 20% IRR is pricing this deal too low for the risk we're taking...we need to see at least 25-30% IRR to do this deal." When they say 20% IRR is priced too low, they're saying the IRR is too low which means that the purchase price we're assuming is too high. This is similar to how fixed income is quoted in terms of yield - a low yield means a bond is expensive...like a low IRR means that a LBO target is expensive, and a high yield means that a bond is cheap...like a high IRR means that you are buying the LBO target on the cheap.

Anyway, long story short, the "input" for the "LBO method" of valuation used in banking is the IRR which is ~20%. From that 20% IRR you back into a purchase price. You ignore the current market price in determining the value. If your LBO at a 20% IRR spits out a value that is way, way lower than the current market price, then the LBO doesn't make sense.

As far as increasing the value of the company through operational changes, it is true that you can do this but in reality, most PE returns are determined by the price you pay and not by the changes you make to the cash flows. The CEO of the public company could also make most of these operational changes and get the same results. Most large public companies are pretty sophisticated and will make these operational changes if the opportunities exist and are identifiable, so there won't be a lot of easy fixes for the PE buyer. In general, when you are running these valuation models at a bank, the cash flow projections you will use for the public company DCF and the LBO are going to be pretty similar (you, or your banking MD, won't know what sort of changes the PE firm could realistically make and if you really did know, you'd be running PE firms instead of banking)

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Jan 20, 2011

DCF goes off management assumptions which are always overly optimistic is the explanation I heard.

Jan 20, 2011
rafiki:

DCF goes off management assumptions which are always overly optimistic is the explanation I heard.

Ya, but you still need to project a fully integrated three statement model for an LBO, it's not like your going to be using pessimistic assumptions, you are going to be targeting a specific IRR.

Jan 20, 2011

For interview purposes just look at Race's comment, that is what they are looking for. Don't talk about an LBO or DD or anything else.

Jan 20, 2011

It's amazing how many negative replies/thrown poop I've gotten on a question that most of you seem to disagree with. Wow.

Jan 20, 2011

Ya people are retarded and use this forum to talk about everything they learned 5 mins ago in financial managment. Just use exactly what Race said and you will be golden in interviews. Don't over analyze because i promise they are looking for those exact three answers, they don't want you to talk about a DD model or an LBO, and if you do that will open pandora's box of questions you are certainly not prepared for.

Jan 20, 2011
HFFBALLfan123:

Ya people are retarded and use this forum to talk about everything they learned 5 mins ago in financial managment. Just use exactly what Race said and you will be golden in interviews. Don't over analyze because i promise they are looking for those exact three answers, they don't want you to talk about a DD model or an LBO, and if you do that will open pandora's box of questions you are certainly not prepared for.

That's not true, I've been asked what the 4 valuation methodologies are in multiple interviews and the answer they were looking or was an LBO analysis to back into a purchase price. What would you use as the 4th if they asked for 4 and you don't want to mention an LBO?

Jan 20, 2011

Race's answer is what an accountant would say. Give that answer if they ask you for 3 (OP said 4) methods and you are interviewing at E&Y. Race's answer is what the accountants at my firm say when I tell them to do the FAS 157 valuations for my portfolio companies (afterwards, I take those valuations and throw them in the trash because they don't mean anything outside of the back office).

If you are interviewing with an investment bank and they ask for 4 methods, they are probably asking for 1) DCF; 2) public equity trading comps; 3) comparable precedent transactions; and 4) LBO (as said in the first reply).

Liquidation value makes sense and is good to consider if you are trying to make an intelligent investment with your own money. However, no M&A banker is going to go pitch an acquisition and show a football field with replacement/liquidation value on it because it's going to show a low-ass valuation and imply that the value of the acquisition target is way, way less than the seller's asking price. If the value of the acquisition target is way, way less than the asking price, then the deal doesn't make sense and the client should not do the deal and not pay the banker fees (oh yeah, banker's are always telling clients NOT to do the deal and not to pay them fees. sarcasm). This does not consider distressed/restructuring type situations where liquidation value would be more relevant.

HFFBALL, you should pause and think a bit before you call people retarded. I have never in my life taken a financial management course, but I have worked in banking and private equity. If you are interviewing for a job in investment banking, you should absolutely mention LBO in your response to the question in the OP because LBOs are very relevant in investment banking. It would also make sense to mention liquidation/replacement value as a 5th method (or as the 4th method if you are grouping equity trading comps and comparable transactions into one "market approach" method), but you won't be dealing much with that method in your day-to-day IB analyst job unless you work in a restructuring group.

HFFBALLfan123:

Ya people are retarded and use this forum to talk about everything they learned 5 mins ago in financial managment. Just use exactly what Race said and you will be golden in interviews. Don't over analyze because i promise they are looking for those exact three answers, they don't want you to talk about a DD model or an LBO, and if you do that will open pandora's box of questions you are certainly not prepared for.

Jan 20, 2011

DCF, Comps, Comp. acquisitions, and replacement value.

Jan 20, 2011
HFFBALLfan123:

DCF, Comps, Comp. acquisitions, and replacement value.

Thanks for that, appreciate your input. I'm not sure that is always the cut and dry case. I have responded LBO as the 4th valuation methodology in an interviewer, with the VP nodding his head and saying, "okay, that's the final one I was looking for."

Jan 20, 2011

I'm editing this to be less harsh because I don't want to be mean, and as the other people on the thread are showing it's not 100% cut and dried.

But I am seriously recommending you spend less time posting on WSO and more time trying to actually learn. The major issues with your posts about 13-Fs could have been solved with 5 minutes on wikipedia and google.

Jan 20, 2011

Kenny - respectfully I disagree.

Jan 20, 2011

SHORTmyCDO......are you a Dec. grad starting as an analyst early? Curious because I will be graduating in Dec. and hope to start early if possible (if I have an offer). If so is it a boutique or BB?

"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger

Jan 20, 2011

Yes I am. I am starting at a boutique, but was able to land two BB interviews for early start dates within the last month, they are just taking forever to move forward in the process and my agreed start date is coming up at the boutique. I would recommend graduating early. I didn't really interview with many BB's during recruitment because I targeted more MM banks since I have a 3.3 from a nontarget, but had 3 super days for MM firms to start in July. Graduating in December, if anything will leave you with more options because a lot of banks will realize they under hired that year, people quit and you can always start in July.

Jan 20, 2011

If you can get an offer this summer after an internship, you shouldn't have a problem starting early.

Jan 20, 2011

Cool, thanks for the advice

"One should recognize reality even when one doesn't like it, indeed, especially when one doesn't like it." - Charlie Munger

Jan 21, 2011

bankbank, I shouldn't have made a broad statement about all posters being retarded college kids. Just amazed that a simple question like what are the 4 valuation methods stirred this much debate....

Jan 21, 2011

bank...thank you so much for that post, SB for you. I think that is the most I've ever gotten out of a post on this site.

Jun 21, 2014

bumping this thread to see if there are any other inputs regarding the subject.

from macabacus: http://www.macabacus.com/valuation/methods

Snootchie Bootchies

Aug 26, 2014

Valuation methods: book value

Aug 26, 2014

bumping this thread see also www.trivex-investment .com
Several valuation methods are calculated.

Aug 26, 2014
  1. DCF 2. Comparable trading 3. precedent transactions 4. sum of parts ?

Sounds like they are asking ways that you can value companies not categories of valuations...

Aug 26, 2014
humble_dude:

1. DCF 2. Comparable trading 3. precedent transactions 4. sum of parts ?

Sounds like they are asking ways that you can value companies not categories of valuations...

  1. LBO
Aug 26, 2014

Right, but even WITHIN each of the categories I listed there are multiple methods, leaving us with more than four. I just didn't understand why he'd ask for a definitive 4.

Aug 27, 2014
wanderlvst:

Right, but even WITHIN each of the categories I listed there are multiple methods, leaving us with more than four. I just didn't understand why he'd ask for a definitive 4.

He asked for 4 because there were 4 he wanted...wtf man. Listen to the question, it's not rocket science. Give him the main 4 (trading comp, transaction comp, dcf, lbo) and move on. Don't try to get fancy with theory, they'll push you if they want it.

Aug 27, 2014
wanderlvst:

"Well there's also the looking at recent deals in the industry method"

= precedent transactions

Aug 27, 2014
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Aug 27, 2014
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Currently: future psychiatrist (med school =P)
Previously: investor relations (top consulting firm), M&A consulting (Big 4), M&A banking (MM)