Valuation is the process of deriving the currently projected worth of an asset or a company. There are many different methods used to produce valuations, and often they have different values. Therefore, it is essential to use the right technique for valuation when evaluating a particular company. Valuations are a vital part of an analyst’s role within a bank or other institution, and they are continually changing due to economic forces in the market. This article provides an outline of many common types of valuations used today.
WACC Method: Step by Step
The weighted average cost of capital (WACC) is a key input in discounted cash flow (DCF) analysis. It represents the rate at which a company’s future cash flows need to be discounted to arrive at its present value. This is an intrinsic valuation method. That method means that it is not borne out by industry averages or market norms. This often means that although it is numerically sophisticated, it can return unrealistic answers.
The step by step guide for this method is as follows:
- Calculate the WACC
WACC = [(Cost of Debt) x (% of Company financed by Debt)] + [(Cost of Equity) x (% of Company financed by Equity)]
- Project the future free cash flow to the firm (FCFF)
FCFF = Net Income + Interest – Capital Expenditure – Changes in Working Capital.
The Capital Expenditure is the money spent on physical infrastructure (e.g., land, buildings, equipment). The Changes in Working Capital is the money required for day to day
- Calculate the present value of the FCFF
- Calculate the Terminal Value and the discount to the present value using the WACC using two potential methods:
(A) The Gordon Growth Model
Enterprise Value = (Present Value of FCF) + (Present Value of the Terminal Value) This method of calculating the terminal value assumes a perpetually constant growth rate after the projection period. Most analysts usually project this at anywhere from 2 percent to 3 percent. They should not be much higher than the long-run growth rate of developed economies, as a company cannot grow faster than its economy forever.
(B) The Exit Multiple Approach
- Terminal Value = EBITDA, FCF, or Revenue for the final forecast year multiplied by an appropriate multiple based on historic levels, or based on comparable companies. It is better to use both of these methods together to check your terminal value, as this can account for 75 percent of the company valuation in some instances. A discount rate of 10 percent and growth in perpetuity of 2.5 percent in the Gordon Growth Model implies an FCF multiple of 14x.
This terminal value can then be discounted to the present. We used the Cambridge University Finance & Investment Society (CUFIS) Technical Guide for this:
Terminal Value = FCFF5 x (1 + long term growth rate)/ (WACC – long term growth rate)
This is a type of relative/market valuation which aims to determine the value of a company by looking at the “multiples” of similar companies (comparable company analysis) or of similar transactions (precedent transaction analysis). Multiples are ratios that are calculated by dividing the value of a company by an operating metric that can be found on the financial statement (e.g., cash flow, operating profit). This method assumes that these ratios will be similar across similar firms. Some examples of common multiplies are EV/EBITDA, EV/ Revenue, EV/EBIT, and the P/E ratio.
Comparable Company Analysis: Step by Step
- Find a selection of comparable companies, known as peers. Typically, five to ten companies are chosen, and these should have similar characteristics to the company you are trying to value. The closeness of a company to the target company is based on a variety of factors such as its size, growth rate, geography, and profitability.
- Calculate the multiples for the peer companies by dividing the company’s value by an operating metric. The value of a company is given by either market capitalisation (this represents the total equity value of a company), which is the stock price multiplied by the number of shares outstanding or enterprise value (EV). The EV represents the total value of a company, including debt, which is:
Market Capitalization + Debt + Preferred Stock + Minority Interest – Cash.
This will be divided by an operating metric such as:
EBIT (Earnings Before Interest and Tax – a measure of operating profit), and EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization – a measure of cash flow).
EBIT = Revenue – Operating Expenses (e.g., rent, equipment, marketing costs)
EBITDA = EBIT + Depreciation Expense + Amortisation Expense
- After calculating the multiples for each comparable company, calculate an average or median of the multiples and multiply this by the appropriate operating metric of the target company.
Precedent Transaction Analysis: Step by Step
This approach involves looking at the price at which similar companies have been recently sold. All you have to do is find a selection of similar companies and calculate the precedent transaction multiples of those peer companies
The multiples used are similar to that for Comparable Company Analysis, except with the latter, we used the company’s market stock price to calculate its value. With precedent transaction analysis however, we use the price paid by the purchaser per share. This is
typically greater than its market stock price, as an acquirer would have to pay an additional control (value ascribed to being able to control a business rather than simply owning a percentage of equity in it) and synergy (the extra value induced when two companies are combined, compared to when they are separate entities) premium.
After calculating the multiples for each comparable company, calculate an average or median of the multiples, and multiply this by the appropriate operating metric of the target company.
This article was written by Marshall Dolan Henshaw, student at Cornell and aspiring financial services professional.