top of page

Understanding the Valuation Methods

ree

Why do we use Valuation? Why is it Important?

  • Valuations are commonly used during M&A deals to get a sense of how much the company is worth (and therefore what the purchase price should be)

  • It is very important to use all forms of valuation (and perform a sensitivity analysis) to get a range of the purchase price

  • Often times, the end result after all four forms of valuation has been performed is visually displayed through what is called a “Football Field,” which clearly outlines the ranges of values for each of the methods


Different Methods of Valuation: 

  1. Discounted Cash Flow (DCF): An intrinsic form of valuation that estimates the value of a company using its expected future cash flows. DCFs are used to determine how much a company is worth today, based on the future value it will create (which is derived using a variety of different assumptions described in detail below). 


  1. Comparable Company Analysis (Comps): A relative form of valuation that derives a company’s value by comparing its financial performance with those of its competitors. Key metrics and forms of comparison include Enterprise Value (EV)/EBITDA, EV/EBIT, Price/Earnings, and a lot more. 


  1. Precedent Transactions Analysis: A relative form of valuation where past M&A transactions are used as an indicator of a company’s current value, and are therefore used to value a comparable business today. Ideally, past transactions should be of companies in the same industry, geographical location, and with similar financial profiles as the company you are currently valuing.  


  1. Leveraged Buyout (LBO): A type of acquisition (usually by a Private Equity Sponsor) where a company is bought using majority borrowed funds (debt) and LP equity. Once acquired, the future cash flows will serve to repay the debt. Finally, the Private Equity owner exits the investment and pays off the remaining debt, with the rest of the return going back to the Private Equity firm and its LPs.


Important Prerequisites: 

  • In order to understand the rest of the guide completely, there are a few suggested items of understanding that are important to grasp before continuing: 

    • Accounting: Have a strong ability to read and make connections between the three financial statements 

    • Equity/Enterprise Value Information: Know the difference between the two, the bridge between them (i.e. how to get from equity to enterprise value and vice versa), and have a general of understanding of what they represent 

    • General Finance Knowledge: Know how to locate and read 10-K reports, Earnings Calls, etc.

DCF - Discounted Cash Flow Analysis

A fundamental valuation method used in finance to estimate the intrinsic value of a company, project, or investment based on its expected future cash flows.


Why DCF?

A DCF is used to determine the fair value of an asset based on its expected future cash flows, discounted back to the present value using an appropriate discount rate (typically the Weighted Average Cost of Capital (WACC) for companies). The idea is that a dollar today is worth more than a dollar in the future due to the time value of money. By discounting future cash flows to its present value, we get its enterprise value (EV), which we can use to calculate the companies (Price per Share).


Calculate Free Cash Flows (Unlevered usually→ UFCF)

UFCF = EBIT * (1-t) + D&A - CapEx +/- changes in NWC


EBIT= Earnings before Interest and Taxes

D&A= Depreciation and Amortization

CapEx = Capital Expenditures

NWC= Net Working Capital


Equation for WACC:

ree

E = Equity

D = Debt

re = Cost of Equity

rd = Cost of Debt

E/V = % of Equity in Capital Structure

D/V = % of Debt in Capital Structure


Once future cash flows are discounted back to Present Value (PV), we need to calculate the Terminal Value (TV) which are cash flow projections for after the period being examined.


There are two methods for calculating the Terminal Value: the perpetuity growth method and the exit multiple method.


Growth Perpetuity / Gordon Growth Method:

ree

FCFn = Terminal Year UFCF

g = Growth Rate (based on GDP growth rate or inflation rate)

r = WACC


Exit Multiple Method:

ree

EBITDAn = Terminal Year EBITDA

Exit Multiple = EV/EBITDA Multiple taken from Comparables


Discount the Terminal Value and sum the value with the discounted Unlevered Free Cash Flows to calculate the company’s implied Enterprise Value (EV) using this formula:

ree

Lastly, we have to back in the equity value, then dividing by the total number of outstanding shares:


Implied Equity Value = Implied Enterprise Value (EV) - Debt + Cash - Preferred Stock - Non-Controlling Interest


Implied Price per Share= Implied Equity Value / # of Fully Diluted Shares Outstanding



Digging Deeper into the DCF

Cost of Equity Equation (CAPM Formula):

ree

re= Cost of Equity

rf= Risk free rate (10 year treasury Bond → Safest possible investment)

B (beta)= Volatility compared to the market (S&P 500)

(rm-rf)--> Equity Risk Premium (ERP)= Excess Return for investing in the market over a Riskless Asset


Levered vs Unlevered 

The term lever means debt. Unlevered FCF’s are unaffected by debt, and Levered free cash flows are affected by debt.

LFCF= UFCF - Interest payments + new debt issued - debt repayments

For LFCF, we just use the Cost of Equity (re) as the discount rate instead of WACC.


Comparable Companies Analysis

Relative valuation technique that estimates a company’s value by comparing it to similar publicly traded companies. It relies on the idea that similar firms should trade at similar multiples given comparable business operations and market conditions.


Why Comps?

This method helps analysts and investment bankers quickly assess market sentiment and benchmark a company’s valuation against its peers, making it a valuable tool for both M&A and equity research.


How to identify comparable companies?

  • Industry: Focus on companies operating in the same industry or subsector

  • Size and scale: Look for firms with similar revenue, market cap, and growth trajectories

  • Geography: Consider companies within the same region, as regional market dynamics can influence valuation multiples

  • Business Model and Operations: Ensure that companies have similar operating models, risk profiles, and capital structures


Where to find information?

  • Bloomberg, CapIQ, Reuters, etc

  • Public financial statements and annual reports (i.e. 10Ks)

  • Industry reports and sector analysis


Important information to collect

  • Key financial metrics (Revenue, EBITDA, Net Income)

  • Market data (share price, market cap)

  • Growth rates and margins

  • Any company-specific nuances that might affect comparability


Key Valuation Metrics and Multiples

  • Enterprise Value Multiples (EV/EBITDA, EV/EBIT, etc)

  • Equity Multiples: (Price/Earnings - aka P/E)



Applying Multiples to the Target Company

First select the financial metric (i.e. EBITDA, EV/EBITDA, etc) that best fits the characteristics of the target company


Valuation Process

  1. Multiply the target company’s financial metric by the range of multiples obtained from the peer group

  2. Develop a valuation band (low, mean, median, high) to reflect market uncertainties

  3. If necessary, reconcile Enterprise Value with Equity Value by adjusting for net debt and cash balances


Advantages

  • Quick and intuitive, offering a real-time snapshot of market sentiment

  • Reflects current market conditions and investor expectations

  • Useful as a cross-check against intrinsic valuation methods like DCF


Disadvantages

  • Dependent on the quality and selection of the peer group

  • Market anomalies or temporary distortions can affect the reliability of multiples

  • May not fully capture company-specific factors, especially for firms with unique business models


Precedent Transactions 

Valuation method in which the price (multiple) paid for similar companies in the past is considered an indicator of a company's value.


Why Precedent Transactions

  • Market Benchmark: Provides insight into what buyers have historically been willing to pay for companies with similar characteristics, often reflecting a premium for control or strategic value

  • Deal Context: Accounts for market sentiment and specific deal conditions at the time of the transactions, which can offer valuable context for current valuations


Identifying Past Transactions

  • Focus on transactions within the same industry as the target

  • Select deals conducted in similar geographical regions to account for regional market differences

  • Ensure that the companies in past transactions have similar sizes, growth prospects, and risk profiles


Where to Gather Data?

  • M&A deal databases (i.e. Bloomberg, Thomson Reuters, SDC Platinum

  • Public filings, press releases, industry reports


What Details to Gather?

  • Deal dates and market conditions at the time of the transactions

  • Deal structures (cash, stock, or hybrid) and any noted premiums

  • Multiples such as EV/EBITDA, EV/EBIT, or other relevant metrics

  • Adjustments for any extraordinary deal factors (e.g., strategic premiums or distressed sales)


Analyzing Transaction Multiples

  • Key Multiples

    • Enterprise Value (EV) Multiples

      • EV/EBITDA

      • EV/EBIT

    • Equity Multiples

      • P/E (if applicable)

  • Normalization and Adjustments

    • Time Effects: Consider the economic and market environment at the time of the transaction.

    • Deal-Specific Factors: Adjust for any unique circumstances such as control premiums, synergies, or distressed conditions that could distort the multiple.

    • Accounting Differences: Normalize for any variations in accounting practices across transactions to ensure comparability.


Advantages

  • Reflects what buyers have been willing to pay in actual transactions

  • Provides real-world deal data and can help anchor other valuation methods

  • Easy to understand and communicate to stakeholders in M&A discussions


Disadvantages

  • The analysis is only as good as the available precedent transactions; data may be limited or not perfectly comparable.

  • Different market conditions may have influenced historical deals, which might not accurately reflect the current environment.

  • Unique factors in past transactions (such as distressed sales or strategic premiums) can distort the multiples if not properly adjusted.


ADDITIONAL RESOURCES AND INFORMATION: 

Common Interview Questions:

  • What valuation typically gives the highest valuation?

  • Valuation Price rank: Precedent transaction > DCF ~ Comps > LBO

  • Reason: transaction premium; related to market conditions; to reach higher internal rate of return (IRR)


DCF:

  • Walk me through a DCF.

  • What is beta and what is an example of high beta and low beta?

  • What is unlevered cash flow/why is unlevered cash flow important?

  • If beta changes, there are three places within unlevered cash flow calculation that will also change. Where?


Precedent transaction/comps:

  • Why might two companies in the same location and same industry have different valuations?


LBO:

  • Walk me through a paper LBO (normal one; one with wrong revenue in a certain year; one generates increasing extra cash flow)

  • How do you measure what is a good LBO candidate?

bottom of page