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Valuation is the primary job of a financial analyst and they use different methods used for valuing the business or investments of the company with the 5 most important valuation methods being comparable company analysis, discounted cash flow analysis, comparable acquisition Comps, Asset-based valuation and Sum of the Parts (SOTP).
An appropriate valuation method is one which has the ability to incorporate all relevant factors that have a material effect on the fair value of Investment. While valuing a business, choosing the correct equity valuation method is extremely important.
When valuing Young companies, start-ups with limited history go for equity from private investors. They do not have a past history & are also susceptible to failure, valuing such companies becomes difficult. However, when valuing public listed stable companies, you have lots of financial information available by way of annual reports and press releases.
In this article, we discuss the Top 5 equity valuation methods that you can use to value a business.
Please do note that correct equity valuation methods depend on the availability of data, Stage of development of Target, the ability of the target to generate positive cash flows in future and the Quality & reliability of data to be used
#1 – Discounted Cash Flow Valuation Method
Below table summarizes Alibaba’s Discounted Cash Flow Valuation model.
- DCF is the net present value (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 model. It is more theoretical approach which relies on various assumptions.
- A DCF analysis helps in yielding 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 value along with 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 cost then the investment opportunity needs to be considered.
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#2 – Comparable Company Analysis Valuation Method
Below is the comparable company analysis of Box IPO Equity Valuation Model
- This equity valuation method involves comparing the operating metrics and valuation models of public companies with that of target companies.
- Using equity valuation multiple is the quickest way of valuing a company. Apart from that, it is useful in comparing companies that doing a comparable company analysis. The focus is to capture 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 value.
- This equity valuation method is used for a target business that has an identifiable stream of earnings or revenue which can be maintained by the business. For businesses that are still at development stage then projected revenue or earnings are used as the basis of valuation models.
Recommended Comparable Company Analysis Resources
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#3 – Comparable Transaction Comp Valuation Model
Below is the Comparable Transaction Comp of Box IPO Valuation
- Value of company using this equity valuation method is estimated by analyzing price that was paid for similar companies in similar circumstances. This kind of valuation method helps in understanding the multiples and premiums paid in a specific industry and how private market valuations were assessed by other parties.
- 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, same industry, and size of the transaction, type of transaction and characteristics of the buyer.
- This equity valuation method saves time to use publically available information. However, the major drawback in 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 draw conclusions. 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 in a different part of the business cycle.
- 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 financial then spreading the key trading multiples and lastly determining the valuation of the company. For example, if your company is predicting to have EBITDA of $200 million in 2016 and the precedent transaction analysis is showing target companies were purchased for 20x EBITDA then your company would be worth approximately $4 billion.
#4 – Asset-Based Valuation Model
- The asset-based valuation method takes into account the value of the assets and liabilities of a business. 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.
This 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 capital of XYZ Ltd.
The following is the balance sheet of the company XYZ ltd.:
|Share Capital 50000||Fixed Asset 735000|
|Reserve and Surplus 400000||Stock 500000|
|Sundry Creditor 700000||Sundry Debtors 700000|
|Bank Overdraft 800000||Cash in hand 15000|
|Total: 1950000||Total: 1950000|
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 Model
A conglomerate with diversified business interest may require a totally different valuation model. Here we value each business separately and add up the equity valuations. This approach is called as Sum of Parts Valuation Method.
Let us understand Sum of the Parts valuation using an example of a Hypothetical company Mojo Corp.
In order to value the conglomerate like MOJO, one can use equity valuation model to value each segment.
- Automobile Segment Valuation – Automobile Segment could be best valued using EV/EBITDA or PE ratios.
- 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 Method to value Banking Sector
- E-commerce Segment – We use EV/Sales to value 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
Valuation Methods Video