Major Valuation Methods

monkeysama's picture
Rank: King Kong | 1,599

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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