Reviewed on 18 February 2020
There are many ways to value a company, but it really depends on what is the company’s nature and in what stage is the company. For example, valuing a company going for liquidation is different from valuing an operating business. What about to value a company that is lost making vs another that is profit making?
Here are the different methods to value a business.
What are the Main Valuation Methods?
There are three main valuation methods used by industry practitioners when valuing a company as a going concern: (1) Market Approach , (2) DCF analysis approach, and (3) Cost Approach. These are the different methods of valuation used in investment banking, equity research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO) and other areas of finance.
Image: CFI’s Business Valuation Course.
As shown in the diagram above, when valuing a business or asset, there are three broad categories that each contain their own methods. The Cost Approach looks at what it cost to build something, and this method is not frequently used by finance professionals to value a company as a going concern. Next is the Market Approach, this is a form of relative valuation and frequently used in industry. It includes Comparable Analysis Precedent Transactions. Finally, the discounted cash flow (DCF) approach is a form of intrinsic valuation and is the most detailed and thorough approach to valuation modelling.
Method 1: Market Analysis Approach
Comparable company analysis (also called “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 valuation method.
An example would be a F&B related business would be compare to another F&B who has just sold or got invested to get its relative P/E ratio. This P/E ratio (for example 6x) will be then use as a multiplier to multiple the EBITA of the potential F&B company with 6x to get its valuation.
Let’s think about valuing a property; the Comparison method is also used to value the most common types of property, such as houses, shops, offices and standard warehouses. Ideally the assumption is that the market should be stable and there should be multiple, recent lettings/sales of comparable properties (same size, location, condition etc). The best comparable factors should be selected and analysed, and thereafter adjustments can be made for their differences. Finally, an estimated market value can be created.
In most country, property valuation is based on the per square feet (or per square meter) price multiply the size of the unit; but how did they derive on the PSF in for that unit? It is also based on comparable analysis on the last few transacted price in the similar area with the same condition.
Below is an example of a valuation analysis using market approach.
Method 2: DCF Analysis Approach
Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the business’ unlevered free cash flow into the future and discount it back to today at the firm’s Weighted Average Cost of Captial (WACC).
A DCF analysis is performed by building a financial model in Excel and requires an extensive amount of detail and analysis. It is the most detailed of the three approaches, requires the most assumptions and often produces the highest value. However, the effort required for preparing a DCF model will also often result 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 larger businesses, the DCF value is commonly a sum-of-the-parts analysis, where different business units are modelled individually and added together.
DCF Valuation Model
(Image: CFI’s Business Valuation Course)
Football Field Chart (summary)
Investment bankers will often put together a football field chart to summarize the range of values for a business based on the different valuation methods used. Below is an example of a football field graph, which is typically included in an investment banking pitch book.
As you can see, the graph summarizes the company’s 52-week trading range (it’s stock price, assuming it’s public), the range of prices analysts have for the stock, the range of values from comparable valuation modeling, the range from precedent transaction analysis, and finally the DCF valuation method. The orange dotted line in the middle represents the average valuation from all the methods.
Image: Free Football Field Chart.
Method 3: Cost Approach
The cost approach, which is not as commonly used in corporate finance, looks at what it cost or would cost to re-build the business. This approach ignores any value creation or cash flow generation and only look at things through the lens of “cost = value”.
This approach is more commonly used for company who has not make any profit or revenue. Many start-ups who has built technology platform can often use the cost to acquire the number of customers as part of the valuation of the business. It literally covers the opportunity cost that the entrepreneur lost when he do this business, including the possible salary he lost during this period of time and the effort he spend and his company’s IP rights, customer acquisition and other database they have built and acquired during this period of time.
If the investor set up a new company on his own, how much does he need to spend to create a company with the exact value as yours. This is the value, which is also the Replacement Cost.
If the company will not continue to operate, then a liquidation value will be estimated based on breaking up and selling the company’s assets. This value is usually very discounted as it assumes the assets will be sold as quickly as possible to any buyer.
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