An Introduction to the Major Valuation Techniques

In investment banking, one of the primary steps to understanding a company, whether for M&A or an LBO, is to put a value on it. Think of it almost like the price that a banker creates that essentially quantifies all the benefits (and drawbacks) of ownership. The main three valuation techniques are Discounted Cash Flow Analysis (“DCF”), Precedent Transactions Analysis, and Comparable Companies Analysis (“trading comps”). All three aim to give the analyst a price point or range based on various inputs and projections, but differ fundamentally in the way they go about doing so and the information they use to create their valuation models.

Discounted Cash Flow Analysis

DCF analysis values companies based on the present value of its cash flows. This is done by estimating, based on assumptions and projections from a careful study of the target and what affects its performance, free cash flows for several years into the future. (Free cash flow is the cash left over after payment of cash operating expenses, taxes, and capital expenditures, but before any interest payment).

Once free cash flows (FCF) has been projected, it is discounted to account for the time value of money. For instance, $100 in your hand today is worth more than $100 received a year from today, primarily due to the fact that those $100 could be working for you, earning a return in an investment such as a stock or bond holding. The discount rate is typically calculated by a weighted average cost of a company’s capital, combining the cost of debt as well as the “cost” of equity from stakeholders (this is NOT free, since investor funds will dwindle or disappear if the company fails to produce a reasonable return based on investor expectations and industry averages). This weighted average calculation is known as WACC (weighted average cost of capital). Projected cash flows are discounted to their present value, and then a terminal value estimation is used to encompass the future at an expected rate of growth or return. These together form the DCF analysis framework for valuation.

Since DCF analysis relies heavily on many assumptions and ideas about a company’s future prospects, it typically aims to produce a range of values based on sensitivity testing of the analyst’s inputs. This also makes it subject to user error, and must be carefully crafted to avoid a highly skewed valuation based on unreliable or unrealistic inputs.

Comparable Companies Analysis

Comparable Companies Analysis is a vastly used method for valuation, since it provides much-needed context. As its name suggests, it takes into consideration what is called the “comparable universe” of companies that are similar to the valuation target. A good place to start is the target’s direct competitors, since they are often offering similar products or services and are by nature in the same industry. Identifying the comparable universe can be difficult, but it is a vital step since comparable companies analysis relies heavily on their financial facts and figures.

Once the universe is identified, financial information can be gathered from the SEC filings such as the 10-K and 10-Q. This information is interpreted either directly or into various ratios and banking calculations (e.g. EBIT/EBITDA, Enterprise Value, and current share price) is put in a spreadsheet for easy viewing. The closest comparable companies, the ones that align most with the target’s operations and profile, are analyzed and their financial information laid out alongside the target’s. As the analyst hones in on the closest comparables and their ratios, those are applied to the target’s financials, and a valuation range is reached.

The caveat here is that since this technique relies on a large amount of judgement and proper selection of the close comparable universe, it too can be easily skewed by improper choices. That is why senior bankers are often overseers of the final decisions and valuation ranges.

Precedent Transactions

This valuation technique gets its name from its derivation of a valuation range based on the financial multiples paid for companies in previous M&A deals. In essence, precedent transactions follows the same path as trading comps, but differs fundamentally at the first step. In precedent transactions, when selecting the comparable universe, the analyst chooses from M&A deals rather than just the current comparables on the market. This is designed to help make the multiples more reasonable when it comes to doing analysis for the target’s sale or purchase. The highest degree of importance is places on the deals that meet the analyst’s criteria and occurred most recently.

Given the difficulty of selecting close comparables from only previous deals, companies that are slightly “farther away” from the target may be used as a comparable when they also demonstrate similar markets and financial profiles. Ultimately, when the universe has been whittled down to the most informative deals, the analyst is often only focusing on a small handful of less than five.

Once the universe of comparable acquisitions has been decided on, they are spread and compared with the target, with the average multiples applied to the target’s own financials to reach a valuation range.

In this technique as well, it is imperative that an appropriate list of comparable acquisitions be decided on, so help from senior bankers is again common.

How These Techniques Work in Tandem

When valuing a company, as we have seen, there are many ways that the three major valuation techniques can fall flat on their own or even be greatly misrepresentative of the facts due to poor inputs and inaccurate guessing. Bankers must be very careful to consider as much as they can and to learn as much as they can about the target and its industry, regardless of which of the above techniques is being used.

Often, since the different techniques can provide quite different valuation ranges based on what they are using as the ground-floor, it can be useful to use two together (or potentially even all if the banker was so inclined to spend the time and effort to have all three for direct comparison). By combining DCF, which is based on cash flow projection, and trading comps, which focuses on trading and financial multiples, the banker can see things with less bias and more information on the target’s potential valuation ranges and where they might overlap or differ significantly.