Company Valuation Methods Summarised
Investment bankers work across an array of sectors and company sizes requiring them to be adaptive in their analysis when advising on a transaction. While each transaction requires a great level of research, tweaking and expertise for advising and execution, there are some basics or foundations on which those analyses can be built on. So today, for everyone aspiring to know what valuations look like or want a summary of all that you could possibly use for your first few months at work or need a kick-off your first technical interview preparation, here is a summary all I know so far about valuations.
Discounted Cash Flow (DCF)
One of the most basic and commonly used valuation methods is the DCF method. As the name suggests, this method focuses on the cash element of the business to work out a valuation for the company. Let’s understand how one can build a DCF (at least in theory) and try to understand the rationale.
There is essentially a formula used which goes as follows:
+ Depreciation and Amortisation
– Capital Expenditures
+ Proceeds from sale of assets
– Tax on sale of assets
– Change in Net Working Capital
= Free Cash Flow
We apply this formula for all the forecast periods (3 years, 5 years, etc.) and then discount them back using a discount rate (generally a Weighted Average Cost of Capital – WACC). Once those have been discounted, we add them all up to get a value. But the catch is, this value only includes the cash flows from the forecast periods. But usually, the company under evaluation is either a going concern (assumed that it will operate forever) or if it is a project, it will have a sale value. So that needs to taken into consideration as well. That value is called terminal value.
This will be better explained with a dummy example:
In the example above, you can see that we have taken 5 forecast periods FY22 to FY26. We start by taking a forecast of the Earnings Before Interest and Tax (EBIT). This forecast comes from the financial model forecasts. On a high level, most of the times, the costs on the profit and loss account are taken to be growing based on Revenue growth and the growth in Revenue is assumed based on multiple factors such as historical growth of the business, industry growth average, industry outlook, life cycle of the business, etc. Forecasting and building a financial model can be a topic for another article. For now, let’s assume we have done all of that good work and calculated the EBIT values for the forecast period.
Now, we need to understand that we are trying to figure out what is the actual CASH earnings of the business is. A business will have to pay off its tax obligations in cash if it is profitable. Hence, we remove the tax we might pay as a business thus coming at EBIT*(1-Tax). This tax rate is the corporate tax rate in the jurisdiction the company is based in.
Then we need to find the Free Cash Flow. It is slightly different than the cash balance because it ignores the debt and equity elements and considers the entire cash earnings of the business. To come to that figure, we need to add back non-cash items such as Depreciation and Amortisation. Capital Expenditure is an actual expense the company will incur and cash will go out of the business. Hence, Capital Expenditure is deducted. Any sale of assets bring taxable proceeds and we adjust those as well.
The Change in Working Capital element can be slightly tough to comprehend so let us break it down a little. Net Working Capital is current assets minus current liabilities (ignoring the cash and bank items). Now why we take the Change in Net Working Capital and deduct it will be clearer with a calculation.
In the calculation above, you can see we have assumed that working capital is dependent on the revenue and forecasted accordingly. In most cases this will make sense because most of the company’s working capital is used to ideally generate revenues. When we get the net working capital positive, it means that the inventory and receivables are more than payables and vice versa. Basically the intuition is that when net current assets are increasing, it means cash is decreasing and hence, the change in the net current assets must be deducted to adjust the cash movement to get to Free Cash Flow.
Now that we have adjusted all the cash elements, we get the Free Cash Flow for each year. The next few steps involve discounting the Free Cash Flow to present value, assume a Terminal Value figure and discount that as well to present value and then find the Enterprise Value by summing up all of these present values. This Enterprise Value represents the value of the firm without considering any debt or equity portions. However, in a ‘debt-free, cash-free’ transaction, we may want to know the total value of the equity of the business. It is a simple process to reach the Equity Value from the Enterprise Value. All we need to do is add back the cash available in the business (excluding the amount which is essential to run day-to-day activities and keep the business alive) and remove the debt amount. In the example image above, you will see I have written ‘Net Debt’ and you don’t see any Cash there. Net Debt is Debt – Cash (to know how much can be paid away with the firm’s existing cash excluding that which is required for day-to-day activities). That Net Debt is then deducted from the Enterprise Value to get the Equity Value. If the net debt is negative, that means there is more cash than debt. So, any left-over cash after paying the debt will form part of the Equity. This is good for the seller because they can command a higher valuation from the buyer. The vice versa happens when the Net Debt is positive.
This may be a little difficult to comprehend at first but when you build a DCF by yourself or go through models in your University assignments or workplace, you will get confident with this concept.
On a side note, I mentioned above that the free cash flow and terminal value are discounted. Let’s get this clarified as well.
WACC – Weighted Average Cost of Capital is the discount rate generally used for discounting free cash flow figures in the forecast period. WACC is just a blended rate of return that all types of investors in the company will get in the set forecast period. The intuition is that if I invest $1 today at 20% simple annual interest then in year 1, the value of my $1 will be $1.2 and hence, if I want $1.2 in year 1 at 20% simple annual interest rate, then I must invest $1 today. The way WACC is calculated is such that we take 4 components – cost of raising debt, % of debt in the company, cost of raising equity, and % of equity in the company. Now both debt and equity investors can earn a risk free rate of return if they keep their money in the bank and not invest in our company. Hence, based on the level of risk, they need a premium return called risk premium. For debt, the premium is usually 0 or very low depending on the investment grade (riskiness and default probability) of the debt raised. For equity, an assumption is made based on the equity risk premium of the country where the company is based in. A beta figure is assumed to understand the level of risk of an investment (equity beta can be taken from the stock market data while debt beta is usually based on external research or, if it is a high quality debt, then just assumed 0). Beta is alway a figure between 0 to 1 with 0 being no risk / fluctuation and 1 being high risk / fluctuation. These assumptions are based on economic data and research published by the government, financial institutions, research agencies etc. One thing to note is that debt is generally tax exempt or at least have tax deductions / benefits (based on the jurisdiction of the country) investment and hence, we have to remove the tax effect from the cost of debt.
Thus, we can calculate:
Cost of equity: risk free rate + equity beta x equity risk premium
Cost of debt: risk free rate + debt beta x risk premium
WACC: Cost of debt x (1 – corporate tax rate) x % debt in the business + cost of equity x % equity in the business
Terminal Value has two meanings. First, in case of a company which is being acquired with no intention of selling anytime soon, terminal value is the value of the remaining life of the business beyond the forecast period. Usually, there is an assumption that the company will never shut down and hence, will live forever. From your math class in school, you will remember the concepts of Perpetuity and Annuity. Perpetuity formula assumes that the cash flows are being received forever and hence we use the same formula to get to the Terminal Value. The formula goes something like: C*(1+g)/r. The C is the free cash flow value we have in the last forecast period; r is the WACC which is our assumed discount rate; and g is the growth rate – the rate at which the company will grow forever. Usually, this growth rate is very low considering the fact that economies go in cycles and hence, when we are normalising it to get to one growth rate, the average will be low. Another way to look at this is that a company cannot grow faster than the economy it operates in and hence, economic growth rate can also be taken as an approximate. Know that this is an educated estimate and hence, having multiple scenarios of different growth rates is beneficial (this is also why Valuation is an art more than pure science).
Second, in case we are valuing a project or if say a PE firm wants to exit at some valuation at the end of the forecast period. If we know the valuation at which there is to be an exit, we may assume the same as terminal value. If not, then we assume the scrap value / sale value approximate of the business at the end of forecast period to get to the terminal value.
DCF is one of the methods that includes highest level of customisation, based on company’s specific characteristics, to get to a valuation in my view. The above was just one and most common way of valuing a company. You can read more on other ways DCF can be built, and the intuition behind all of the steps here.
Precedent Transactions or Transaction Comps
A much simpler method of getting to a valuation is using precedent transactions. These essentially refer to the past transactions in the industry for similar businesses. We take a multiple from those transactions to get to a range of valuation. Depending on the sector, the multiple varies – for asset heavy businesses, the multiple could be taken on EBITDA while for some there are industry specific multiples. A lot of thought is put into this method as well. Let us dig it a little with a dummy example.
In the above example, there are a number of past transactions in the security service space in the UK. However, if we take all past data, it would include a vast number of entries and some transactions so old that they won’t be relevant anymore. Hence, it is best to filter out the data based on how similar the business is to the one we are valuing, how old we want to go back to (generally 5-7 years is decent enough), size of the company being bought (called ‘Target’) and removing any outliers with significantly high or low figures in deal value, multiples, etc. Once we have referred to all databases and news possible, and the data is robust, it is then best to take an average or median to get an approximate of what Multiple we should assume to calculate the Enterprise Value (i.e. if the Revenue Multiple or EV/Revenue is say 2x then we take the recent revenue figure of the company being valued and multiply it by 2 to get Enterprise Value). The process to get to the Equity Value is the same as we used in the DCF.
Listed Comparables or Trading Comps
Similar to the precedent transactions method, listed comparables simply takes the multiples at which listed companies in the similar industry are trading at. Again, the multiple varies from industry to industry (EBITDA multiple, Revenue multiple, etc). Let’s see a dummy example for this one as well.
For this data, we filter out a list of publicly listed companies as close as possible to the business we are valuing. We then extract all public information of these companies including share price, market equity value, enterprise value, multiple, etc and find an average or a median to get to a multiple that we can use to finally value our company.
Note, these two ‘comps’ based methods are very flexible and can be adjusted to get a sensible valuation. However, one thing they lack is the chance to add the value that is driven by specific characteristics of the business we are valuing or specific transaction synergies we may know of.
A general observation is that for an average company in an average industry:
- The DCF will usually produce a lower valuation because there is flexibility of being as restrictive as possible in the assumptions (however, as discussed above, we can take best, average and worst case scenarios to get a range)
- The precedent transactions will produce a relatively higher valuation because transactions usually consider an element of synergies of acquisition or merger and hence, there is a ‘premium’ involved in the valuation paid
- The listed comparables reflect market expectations of how much a set of similar companies be valued at which can be important if we are looking at a public company whose share value will be impacted with the deal announcement, especially because of the valuation at which the transaction is executed
Valuing a Bank / Financial Institution
Banks and financial institutions are valued quite differently to the above methods simply because of the nature of their business. Let us take banks as an example. Their business is to receive cash and pay an interest on it, lend that cash and earn an interest from it. That’s a very toned down, simple version of what they do. Hence, their main income is interest and assets are cash and debt given! Plus, they are highly regulated and require to hold minimum ‘capital’ on their balance sheet for a bad day. With theoretically no hard assets, how do we value a bank? This is where we introduce 3 new methods – dividend discount model / excess capital model, cash flow to equity model and regression analysis. Let’s understand these in a little more detail.
Dividend Discount Model / Excess Capital Model
On a very high level, because banks do not really have hard assets as much as other companies, we cannot really get an EBIT / EBITDA to make a DCF with Free Cash Flow for the firm without debt and equity elements. Hence, instead of getting Enterprise Value, we directly get the Equity Value. One of the ways to get equity value is Dividend Discount Model. It assumes that the value of a bank’s shares are dependent on the dividends shareholders receive in the future. A simple way is to assume a dividend growth rate (if available or a researched estimate) at which the current dividend will grow over the years. If the annual returns of the banks states specific amount of dividend to be given in the future then we may assume those figures but usually this is only given for 1 year and on quarterly basis. If the growth rate is not given anywhere then one of the ways we may assume a dividend growth rate is by understanding the firm’s payout policy which may include terms such as payout ratio or retention rate, and return on equity (ROE). The payout ratio defines how much amount of total profits will the firm pay out as dividends. Retention Rate is 1 minus payout ratio i.e. how much the firm would like to retain in the business and rest can be given out as dividend. ROE is Net Profit divided by total value of shareholder’s equity (i.e. return generated on the shares). Growth rate is basically: earnings reinvested in the bank times return generated on shares. This calculation gives us the dividend forecast for the bank but like free cash flow where cash flows need to be discounted, these future dividend values must also be discounted to get to a present value figure. This can be discounted using a cost of equity estimate because we are looking only at the equity portion of the business here. Note, there are ways to make this discount rate more dynamic using things like Fama-French model but that will be a little complicated to explain in this article.
Second portion of the valuation includes Excess / Deficit Capital forecast. This is the step that makes bank valuations different. All banks across the world need to maintain certain level of capital on their books which is prescribed by the regulatory authority that applies to their jurisdiction. There are many layers of capital they need to maintain but the most crucial one is Tier 1 Capital. If a bank cannot maintain Tier 1 Capital, it is highly likely the bank is struggling and needs a turnaround or government backing very soon. This Tier 1 capital requirement is given as percentage of the Risk Weighted Assets (RWA) of the bank. Note, a bank’s assets are the loans given by the bank where there is a risk of default. Hence, based on the risk element of each loan, risk weighted assets are calculated. Hence, if the tier 1 requirement is 5% and if a bank has $100 in Risk Weighted Assets, then it’s tier 1 capital requirement is $100×0.05 = $105. Hence, to get excess returns, we calculate a difference between the required level of tier 1 capital and actual tier 1 capital on the annual returns and multiply this return with RWA. We can forecast these excess returns for our forecast period and discount it the similar ways discussed above. Usually, this capital range does not move dramatically and hence, it is like a fixed portion or the minimum level of valuation a bank can get.
The value we get from discounting and adding all dividend forecasts are then added to excess capital to get equity value. Dividends are a variable figure because the bank may not pay dividend in a recession or difficult circumstances. Enfin, the equity value is simply the sum of present values of the dividends forecasted and the excess capital forecasted.
This sounds very complicated but when we do it practically on a bank, it starts making sense. The industry is highly regulated and hence requires a different way to value.
We can also use DCF’s second approach i.e. using the Cash Flow to Equity Model. In this method, we calculate the Free Cash Flow to Equity where we take the Net Income directly and adjust for any investments made or removed from the regulatory capital requirement (i.e. any positive or negative change to the mandatory capital requirement which can be tier 1, tier 2, etc.) and adjust for any planned change to equity capital (e.g.: if there is a buyback planned, then the value will be deducted). This cash flow can be forecasted for the forecast period and discounted using the cost of equity. We add this present value to the present value of forecasted excess capital (discussed in the dividend discount model) to get to the final equity value.
Another way to get a valuation is by conducting a regression analysis of Price over Tangible Book Value (P/TBV) to Adjusted Return on Tangible Equity (RoTE). In this, we take the P/TBV and RoTE of all the listed banks in the jurisdiction (similar filters to listed comparable method). We then find the slope to get a regression line. While the regression line is the optimal level of value at which the banks are supposed to be, it is a good way to analyse whether the bank is under or over valued and also a good way to compare where all bank valuations lie within the matrix.
There are a few other ways to value banks as well but these are the most basic ones (and highly simplified) in my view. Using them all together will be useful to get a range of valuations. Valuing financial institutions in general is very different because their balance sheets are structured differently, they are highly regulated and closely correlated to the economic performance. Hence, we can discuss the intuition behind bank valuation and how economic cycles affect banks and their operations in another article some time in the future.
Valuing a Start-up
Most of the above discussed methods either use historical figures or revenue or industry multiples to get to a valuation. For a startup however, there is no history to rely on, no revenue may have been generated, and sometimes they are so niche that there is almost no industry data. What can we do in this case? How do investors put a value to startups? While there are many methods used, following are some of the ways I know of valuing a startup. Using run-rate estimates along with industry multiples if available (precedent transactions and/or listed comparables) or multiples of industries it offers its services or product to; and if available, based on the value from the last funding round. Hence, I would say that valuing a start-up requires loads of experience and creativity to form an analysis based on a very limited amount of data. This could be a topic for another article since there are many ways one can look at a start-up based on its key characteristics, probability of failure and kind of funding it is raising.
I think of Merger Model as a deal evaluation model because in simplest terms, we are looking at the combined entity’s P&L, cash, debt and equity impact. Based on the final impact on the Price-Earnings ratio (PE ratio) negotiations could be advanced on whether the valuation assumed or offered is acceptable or not and whether an accretive deal or a dilutive deal is more beneficial for the client.
In simplest terms, a few assumptions are taken such as an offer value on the shares of the Target, estimated value of synergies, and sources and uses of funds. Based on this information, relevant adjustments are made on the Balance Sheet and Income statement of the buyer as well as the target. For example, if $300 is paid in cash as part of the transaction then $300 will be deducted from cash line item on buyer’s balance sheet and add $300 in target’s balance sheet. Then, we build the combined balance sheet and income statement by simply adding all the line items of target and buyer as well as accounting for any adjustments. In this process, there will be an element of goodwill created (difference between the assets and liabilities in the combined firm). This goodwill is calculated simply by taking total offer value and deducting the tangible book value of the Target. Tangible book value can be calculated in a few ways, one of those is to take Total Assets and deduct the intangible assets and deduct the total liabilities. This goodwill is adjusted to get the balance sheet of combined entity.
Once we have the combined figures, we evaluate whether this deal is accretive / dilutive and whether that is beneficial for either or both parties or not. The following example snippets will make the calculations clearer:
On a high level, we can calculate accretion / dilution without any adjustments or synergy assumptions, simply based on offer value assumption to get an idea of where the decision is heading. You can see how we can do that below using a simple formula:
Finally we calculate Accretion / Dilution using the Earnings Per Share (EPS – total net income divided by the number of shares outstanding) of the combined entity and the buyer.
Accretion / Dilution amount is the difference between the EPS of the combined firm and the buyer. The percentage of accretion / dilution is this difference divided by buyer’s EPS. We might think that Accretion (i.e. EPS of combined firm higher than the buyer’s EPS) is always good for the buyer. However true that may be, some buyers may also prefer a dilutive deal. For example, if the buyer believes that the deal will be beneficial long term to generate a higher EPS then it may still go ahead with a dilutive deal. A classic example of this is the acquisition of LinkedIn by Microsoft where Microsoft justified the c.1% of dilution with the amount of long-term synergies the deal brought to Microsoft.
Leveraged Buyouts (LBOs) are a way in which an investor buys out an entire company by raising a high amount of debt which the company has to repay over the course of time. There are 2 dedicated articles explaining LBOs – Leveraged Buyouts and how returns are evaluated. Links to the articles:
Usually this analysis is used by Private Equity houses to evaluate the deal and exit possibilities.
The above list of valuation techniques is not an exhaustive list at all. There are many more methods and many more ways of looking at these valuation methods / calculating the value. But, I hope this article has helped you get a flavour of what investment bankers do on the technical side or what topics an investment banking technical interview would cover. While calculating a value is a part of the job of an investment banker, a bigger part of their job is to build a network, client-relationships, advice on the right course of action and negotiate as well as manage a transaction process for the client. This requires people skills which can be built with practice and exposure.
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