Here we will review some of the most commonly used method by PE and VC firms and some Investment Banking company.
1- Introduction
2- Discounted Cash Flow
- Free Cash Flow
- Cost of Capital (WACC)
- Terminal Value
- DCF Advantages and Disadvantages
3- Multiples
- Methodology
- 3 steps to follow
4- Transactions multiples
5- Conclusion
1- Introduction
There are several methods to do company valuations. Theses methods have to be overall understood and accepted by both parties the acquirer and the acquired. But also other participants will need to easily understand and compare the valuations and reasons for such price tag.
These methods can vary according to time, fashion, industry maturity and latest trends of the industry.
We will review in more the discounted cash flow methods commonly used across all industries, then the multiples to conclude with transaction multiples.
In the conclusion there will be some examples of company valuation.
2- Discounted Cash Flow (DCF)
- Free Cash Flow
The FCF or FCFF (precisely named Free Cash Flow to the Firm) is the base line for the calculation of the DCF. It represent the cash available to pay all shareholders, creditors, and pay back interests of long term debts.
It is calculated as follow:
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| Free Cash Flow |
- Realistic growth projection
- Coherence of budgeted growth with investment
- Internal Rate of Return (IRR) is above the cost of capital (also named hurdle rate)
- The ratios and margins needs to be in coherence with historical data
The estimation of the future cash flow are usually on a 5 to 10 years and will vary according to the sector industry and historic data.
The precision in the projection depends on several assumptions and hypothesis that will require sensitivity analysis to understand and assess their overall impact.
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- Cost of Capital (WACC)
Once the FCF has been calculated it has to be discounted at the weighted average cost of capital WACC.
The WACC represent the hurdle rate, the minimum return the project need to comply with in order to create value for the different stakeholders of the project.
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| WACC Cost of Capital |
rD the cost of debt is the market interest rate the firm has to pay on its borrowing, it depends on :
- the general level of debt (function of the capital structure)
- the default premium
- the firm tax rate
Usually it is approximated as :
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rE the cost of equity is the risk associated to the capital structure of the company and intrinsically the expected by the equity holders. According to the CAPM model (most used method)
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| Cost of Equity |
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| Beta |
β<1 the company has a lower risk than the index and a lower return
- Terminal Value
The calcul of the Terminal value can be done according to the Gordon Model or using the Terminal Value with multiple
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| Terminal value using the Gordon Model |
The calculation of the Terminal Value using multiples is usually computed using the projected EBITDA (or Net Earnings, or any other stable multiple) in n+1.
- DCF Advantages and Disadvantages
Advantages:
- The DCF is a sophisticated method that takes into consideration various hypothesis (cashflow, growth and risk). The more precise this hypothesis will be the more indicative the value will be. This is particularly useful when little historic data are available, it is a new company / sector with high growth potential.
- The DCF estimate the intrinsic value for a business. It gives a valuation independent of the market performances on the short term
- The cash flow and the actual market will lead you to the minimal hurdle rate the company should work at.
- The DCF gives is a tool that allows to mitigate the hypothesis on the longer term, and also provide the possibilities to run scenario analysis to adjust the final company valuation number.
- It forces the management team to project and budget on a longer term the potential upside or downside of their business
Disadvantages:
- Due to the sophistication of the method, not only the hypothesis may be imprecise but also the interpretation of the comparison elements to be used may lead to some distortion in the final value
- To agree on all the different variables may be time consuming as they will need to be discussed in details.
- Miss-predictions on the cash flows and on the discount rate (WACC) may lead to significant value differences.
3- Multiples
The method of the multiples is more commonly used as more accessible to non financial experts. It is based on the assumption the market are efficient and the shares value represent the fair price. It is not only based on historical data but also on forecasted revenues.
Technically it is not as rigorous as the DCF and would require accounting adjustment and interpretations as no 2 companies are identical.
However it's greater virtue, being easy to compute, makes it widely accepted and recognised in the financial market.
- Methodology
Phase 1 : Identify and select comparable companies
It is key to identify companies in a the same market addressing the same market segment and share the same characteristics as the company under valuation.
Some elements to be looked at:
- Sector / Market
- Geography
- Market share
- Company structure
- Diversification in Product/Service mix
- Growth Potential
- Margins, Profitability, Capex, etc...
Phase 2 : Select and calculate the adequate multiples
According to the market and sector of the company several multiples will need to be used:
Here is a non exhaustive list of the commonly used multiples
PER or P/E
Price earning ratio : is the current stock price of a company divided by its earning per share
Price for Cash Earnings
Cash earnings represents the cash flow generated on a per share basis.
It is Cash Earning = Operating Cash Flow / # Shared outstanding
Price for the Book Value
The P/B ratio is the market price of a company's shares over its book value.
It compares the cost of a stock to the value of the company it it was broken up and sold today.
Price for the Dividend Payout Ratio
The Dividend Payout ratio is the Dividends per common shares over the earnings per share.
Dividends are the ultimate cash return for shareholders. The dividends payout policy is subjective and closely related to the industry. It gives an indication on the growth potential of the company and it needs for cash.
Other multiples based on the Enterprise Value would need to be compared
EV/Sales: Multiple less subject to accounting principles differences, it allows comparisons of business independently to their country of origins
EV/EBIT: It is usually simpler to compare than using the EBITDA as capital and taxes may differ. It is another way to compare company and gets closer to the Cash Flow method
EV/NOPLAT: It is similar to the EV/EBIT but takes into account capital and taxes. If a company was to finance its growth through personal means, NOPLAT would equal Profits.
EV/OpFCF: This multiple requires the construction of Operating FCF as it is not usually directly accessible and therefore may lead to interpretation and manipulations
EV/Capex: This multiple is used in sectors where the tangibles assets represent a key element of the company's business.
Phase 3 : Company valuation
Once all adequate companies and relevant multiples are selected, it remains to multiply the financial results of the company to get its enterprise value.
It is common to use a combination of these multiples and apply an average or a weighted average.
4- Transactions multiples
This method is a logical technic based on the trends on the industry. it depends on whether the sector is closely followed by investors and the price they are willing to pay. Therefore it is based on research on similar transaction that occurred in the past or recently.
The identification of these data can be relatively complicated to obtain due to the opacity of the deals or the confidentiality of the deals.
These transaction multiples are therefore more volatile and can be subject to speculations.
Here are other widely used multiples allowing comparison in the transactions:
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| Some examples of transaction multiples |
5- Conclusion
This is an intend to be an introduction to the multiples company valuations that are used and accepted. It is based on three main pillars the discounted cash flow, the multiples valuations and the transaction multiples related to the sector with its exit strategies.
Even if some of these multiples valuation look simple they can be subject to significant interpretation and manipulation. It reflects the value of a company comparatively to its selected (more or less similar) peers. As it is not so rigorous it needs to be compared and contrasted with the more rigorous DCF method.
The DCF is based on the cash flow analysis and takes into account the time value of money. It covers a much longer projection and prediction on the business. Despite the initial hypothesis being often uncertain and questionable it remains a very well used method less subject to manipulations.
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