Business and Company Valuation; Discounted Cash Flow and Multiples

Business and Company Valuation

“What is a business worth?” Although it seems simple, determining the value of any business requires experience, sound judgment from market and industry experience and at least some understanding of financial analysis.

Underpining everything that is outlined below however (much of which I sourced from wstselfstudy.com), I am certainly a part of the Warren Buffet school of thought that outlines that it is important to be able to understand a business before you decide it is the business for you.

What a company is worth is commonly different between buyers and depends on several factors including:

  • Assumptions regarding the growth and profitability prospects of the business,
  • An Assessment of future market conditions and demand,
  • Assumptions based on the competition in the market,
  • Varying appetites for assuming risk (the discount rate on expected future cash flows)
  • What unique synergies may be brought to the business after the purchase.

The purpose of this article is to provide an overview of the basic valuation techniques used by financial analysts to answer the question in the context of a merger or acquisition.

Basic Valuation Methodologies

There are several basic analytical tools that are commonly used by financial analysts to determine the value of a company or business. These methods are based on financial theory and market reality but it must be remembered that these tools are only indicators and should not be viewed as a final definitive statement of value, but rather, as a starting point to estimate value.

The Wall Street Self Study course notes that different people will have different ideas on value of an entity depending on factors such as:

  • Public status of the seller and buyer
  • Nature of potential buyers (strategic vs. financial)
  • Nature of the deal (“beauty contest” or privately negotiated)
  • Market conditions (bull or bear market, industry specific issues)
  • Tax position of buyer and seller

Each methodology is fairly simple in theory but can become extremely complex. They include:

“DCF” – Discounted Cash Flow Analysis

The free cash flows to a company are discounted over projection period. This method is especially relevant where there aren’t any comparable companies allowing the use of the multiples methods below or for smaller companies.

In a DCF analysis, free cash flows are modeled over a projection horizon and then discounted to reflect thier present value in today’s dollars (i.e less). In addition to these cash flows, a value must be determined for the cash flows generated beyond the projection horizon, commonly called the “terminal value”. Thus, DCF accounts for time value of money and relative risk of investment, but is highly sensitive to the discount rate.

The DCF approach is among the most scientific and theoretically precise valuation methodologies because it relates specifically to the profitability and growth of the business being valued. Due to its dependency on the discount rate and a number of long term future assumptions, it must be remembered that it needs to be used in association with other methods.

Analysis of Selected Publicly Trading Companies or Selected Acquisitions using Multiples

A part of most valuation methodologies is the idea of a ‘multiple’. A multiple is simply a ratio of value to a financial statement statistic such as Revenue, EBITDA, EBIT and the Price / Earnings (PE) ratio (Check here for Company Valuation Definitions of these ratios). Each of these multiples are common in different industries for different reasons. In general, the higher the multiple, the higher the value given to the future earnings or cash flow of a company; in other words, the higher the multiple, the more a buyer will pay for the company.

An an examples, If a company’s LTM EBITDA was $50 million and similar companies were trading at a 7X EBITDA multiple, the company would have an implied value of $50 million X 7 or $350 million based on an LTM or trailing basis.

The following is a brief overviewe of the two common methods that are used in selecting appropriately similar company multiples:

Trading Comparables (“Trading Comps”) Analysis

Trading Comps is the term for multiples analysis of publicly traded companies and then making comparisons with other similar or comparable companies.

This method is most relevant for valuing public companies with publicly traded competitiors. A major disadvantage of this valuation method is that often, it is difficult to determine the appropraite competitor and number of variables can get in the way.

Deal Comparables (Deal Comps”) Analysis

Deal Comps or analysis of selected acquisitions are very similar to trading comps except that deal comps compare actual completed transactions instead of publicly traded companies as the domain of comparable companies.

This approach is very relevant in the absence of public traded competitors but information can be very scarce and unreliable depending on company and the particular industry.

Other Methods

The following are other methods that I will not go deeper into in this article:

Asset Valuation – Involves analysis of tangible asset

Break up Analysis – Involves sum of parts analysis based on different business lines

LBO Valuation – Involves financial engineering based on leverage or use of debt

9 thoughts on “Business and Company Valuation; Discounted Cash Flow and Multiples”

  1. Expect some massive price moves from Leighton this year, although a recent article in the Fin from JP Morgan valued the company at $20/share, the company has a very strong balance sheet, debt to equity of less than 0.5, in fact a years profit could payout their debt. Leighton have $37billion in forward work, although they are marking down some asset values, their reliability as a contractor for infrastructure work will see them with plenty more work, as some cash strapped contractors give up contracts through lack of funding, this is where Leighton will pick up more work and then of course there’s the Governments massive fiscal expansions which we are yet to see, also expect more as you would from Labour Governments, all looks good for Leighton, just based on current work, their Discounted cashflow value is around $30/share, include all the other potential work (even if we discount the revenues from Dubai) the stock is well undervalued.

  2. Well constructed article Mr Cox.. Would have been nice to have a concise definition like this during Uni days..

    I have written an article about Valuation of Social Media websites on my Blog (Facrbook Twitter etc).. You, and others, may like a look..

    http://behindthefinance.blogspot.com

    All the best,

    Mason

  3. After reading this post, it gives me an great idea of how Warren Buffet, the billionaire successfully keep on playing millions of gains by just buying business.

    He is quite expert on making sound judgment of what profitable business to buy.

  4. Great post James.

    I totally agree that all the tools discussed above give an indication of value rather than a definitive value.

    I would say some or all of these valuation tools should be used to get a range of values for a company. Based on this range you can then make a investment decision.

    Keep up the good work.

    Brett

    NOTE: Despite the above people should ensure their assumptions are sensible otherwise there is no use doing any analysis.

  5. Very good article. Business valuations must be accurate and objectively performed by an outside professional firm who specializes in such reporting. It is also highly recommended to obtain a business valuation on an annual basis to understand the direction of the business and to have the knowledge and time to change course as needed to increase the future value of the company.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>