Equity Valuation Methods
Valuation methods are the methods to value a business/company which is the primary task of every financial analyst and there are five methods for valuing company which are Discounted cash flow which is present value of future cash flows, comparable company analysis, comparable transaction comps, asset valuation which is fair value of assets and sum of parts where different parts of entities are added.
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.
#1 – Discounted Cash Flow
The 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 models. It is a more theoretical approach that 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 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, then 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 the operating metrics and valuation models of public companies with those 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 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 value.
- This equity valuation method is used for a target business with an identifiable stream of revenue or earnings, which can be maintained by the business. For businesses that are 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 value of the company using this equity valuation method is estimated by analyzing the 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, the 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 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 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 cycleBusiness CycleThe business cycle represents the expansion and contraction of the economy that occurs due to ups and downs in the gross domestic product (GDP) of a country. It is experienced over the long term and goes parallel with the natural growth rate..
- 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
- The asset-based valuation method takes into account 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.:
|Share Capital||50000||Fixed AssetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.||735000|
|Reserve and SurplusReserve And SurplusReserves and Surplus is the amount kept aside from the profits that are to be used either for the business or for the shareholders to pay out dividends. Reserves and surplus is reflected under shareholders funds in the balance sheet.||400000||Stock||500000|
|Sundry Creditor||700000||Sundry Debtors||700000|
|Bank Overdraft||800000||Cash in hand||15000|
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.
In order to value the conglomerateConglomerateA conglomerate is a company or corporation made up of different businesses that operate in various industries or sectors, often unrelated. It holds a stake in multiple smaller companies that choose to manage their business separately to avoid the risk of being in a single market, thus, taking advantage of diversification. 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
Valuation Methods Video
This article has been 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 –