Equity Valuation Methods
Valuation methods are the methods to value a business/company which is the primary task of every financial analyst. There are five methods for valuing company: Discounted cash flow which is present value of future cash flows. Comparable company analysis, comparable transaction comps, asset valuation, the fair value of assets and sum of parts where different parts of entities are added.
Table of contents
List of Top 5 Equity Valuation Methods
- Discounted Cash Flow Method
- Comparable Company Analysis
- Comparable Transaction Comp
- Asset-based Valuation Method
- Sum of the Parts Valuation Method
Let’s discuss each of them in detail.
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#1 – Discounted Cash Flow
The below table summarizes Alibaba’s Discounted Cash Flow Valuation Discounted Cash Flow Valuation Discounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance.model.
- DCF is the net present valueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not. (NPV) of cash flows projected by the company. DCF is based on the principle that the value of a business or asset is intrinsically based on its capability to generate cash flows.
- Hence, DCF relies more on the fundamental expectations of the business than on public market factors or historical models. It is a more theoretical approach that relies on various assumptions.
- A DCF analysis helps yield the overall value of a business (i.e., enterprise value), including both debt and equity.
- While calculating this, the present value (PV) of expected future cash flows is calculated. The disadvantage of this technique is an estimation of future cash flow & terminal valueTerminal ValueTerminal Value is the value of a project at a stage beyond which it's present value cannot be calculated. This value is the permanent value from there onwards. along with an appropriate risk-adjusted discount rate.
- All these inputs are subject to substantial subjective judgment. Any small change in input changes the equity valuation significantly. If the value is higher than the cost, the investment opportunity needs to be considered.
#2 – Comparable Company Analysis
Below is the comparable company analysis of the Box IPO Equity Valuation Model
- This equity valuation method involves comparing public companies’ operating metrics and valuation models with those of target companies.
- Using equity valuation multiple is the quickest way of valuing a company. It is also useful in comparing companies that do comparable company analysis. The focus is to capture the firm’s operating & financial characteristics, such as future expected growth in a single number. This number is then multiplied by a financial metric to yield enterprise valueEnterprise ValueEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt..
- This equity valuation method is used for a target business with an identifiable stream of revenue or earnings, which the business can maintain. For businesses still at the development stage, projected revenue or earnings are used as the basis of valuation models.
#3 – Comparable Transaction Comp
Below is the Comparable Transaction Comp of Box IPOBox IPOThe analysis of the Box IPO valuation can be done using various methodologies which are Relative Valuation – SaaS Comparable Comps, Comparable Acquisition Analysis, Using Stock-Based Rewards, Valuation cues from Private Equity Funding, Valuation cues from Dropbox Private Equity Funding, and Discounted Cash Flow Approach for Box IPO Valuation. Valuation
- The company’s value using this equity valuation method is estimated by analyzing the price paid for similar companies in similar circumstances. This kind of valuation method helps understand the multiples and premiums paid in a specific industry and how other parties assess private market valuations.
- This equity valuation method requires familiarity with industry & other assets. When choosing companies for this type of analysis, one needs to keep in mind that there are similarities between factors such as financial characteristics, the same industry, size of the transaction, type of transaction, and buyer characteristics.
- This equity valuation method saves time to use publicly available information. However, the major drawback of this valuation technique is the amount and quality of the information relating to transactions. Most of the time, this information is limited, making it difficult to conclude. This difficulty gets aggravated if the company is trying to account for differences in the market conditions during previous transactions compared to the current market. For example, the number of competitors might have changed, or the previous market might be different in theThe business cycle refers to the alternating phases of economic growth and decline. business cycleBusiness CycleThe business cycle refers to the alternating phases of economic growth and decline..
- While every transaction is different and thus makes direct comparisons difficult, precedent transaction analysis does help provide a general assessment of the market’s demand for a particular asset.
- So valuation in this type of analysis would be first selecting a universe of transactions, locating the necessary financials, then spreading the key trading multiples, and lastly, determining the company’s valuation. For example, if your company is predicted to have an EBITDA of $200 million in 2016 and the precedent transaction analysis shows target companies were purchased for 20x EBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business's performance with that of its competitors.EBITDAEBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business's performance with that of its competitors., then your company would be worth approximately $4 billion.
#4 – Asset-Based
- The asset-based valuationAsset-based ValuationAsset-based valuation refers to one of the approaches used to calculate the value of a business. It values a business based on the assets it possesses. method considers the value of the assets and liabilities of a businessLiabilities Of A BusinessLiability is a financial obligation as a result of any past event which is a legal binding. Settling of a liability requires an outflow of an economic resource mostly money, and these are shown in the balance of the company.. Under this approach, the value of a business is equal to the difference between the value of all its relevant assets and the value of all its relevant liabilities.
It can be easily understood by the following simple Illustrative example:-
The Directors of a company, ABC Ltd, are considering the acquisition of the entire share capitalEntire Share CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side. of XYZ Ltd.
The following is the balance sheet of the company XYZ ltd.:
Valuation by using Asset-Based Approach:
|Cash in hand||15000|
|Total assets-Total Liabilities||450000|
|Value of the company||450000|
#5 – Sum of Parts Valuation Method
A conglomerate with diversified business interests may require a different valuation model. Here we value each business separately and add up the equity valuations. This approach is called a sum of parts valuation method.
Let us understand the Sum of the Parts valuationSum Of The Parts ValuationSum of the Parts Valuation is a valuation method wherein each of the subsidiary or segment of a Company is separately valued & then all of them are added together to estimate the business’s total value. using an example of a Hypothetical company Mojo Corp.
To value a conglomerateConglomerateA conglomerate in business terminology is a company that owns a group of subsidiaries conducting business separately, often in distinct industries. It reflects diversification of operations, product line and market to allow business expansion. like MOJO, one can use an equity valuation model to value each segment.
- Automobile Segment Valuation – Automobile Segment could be best valued using EV/EBITDA or PE ratiosPE RatiosThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. .
- Oil and Gas Segment Valuation – For Oil and Gas companies, the best approach is to use EV/EBITDA or P/CF or EV/boe (EV/barrels of oil equivalent)
- Software Segment Valuation – We use PE or EV/EBIT multiple to value Software Segment
- Bank Segment Valuation – We generally use P/BV or Residual Income MethodResidual Income MethodResidual income refers to the net earnings an organization possess after paying off the cost of capital. It is acquired by deducting the equity charges from the company's net profit or income. to value Banking Sector
- E-commerce Segment – We use EV/Sales to value the E-commerce segment (if the segment is not profitable) or EV/Subscriber or PE multiple.
Mojo Corp Total Valuation = (1) Automobile Segment Valuation + (2) Oil and Gas Segment Valuation + (3) Software Segment Valuation + (4) Bank Segment Valuation + (5) E-commerce Segment.
This article is a guide to Valuation Methods. Here we discuss the top 5 equity Valuation Methods – Discounted Cash Flow Method, Comparable Company Analysis, etc. You can learn more about accounting from the following articles –