One question that frequently comes up in finance interview questions (especially in investment banking) is: “How do you value a company?” This article runs you through several common valuation methods, and provides you with some ideas you could draw on in your upcoming interviews.
First, it’s useful to recognise that there are several types of valuation methods. From first principles, the intrinsic valuation method is frequently used if a company has stable cash flows and capital structure. The discounted cash flow (DCF) method is an intrinsic valuation. In this method, the equity value of a company is calculated by taking the sum of the company’s value in the forecast period and the terminal period. In the forecast period, the company’s future cash flows are forecasted, before being discounted to the present using the weighted average cost of capital. In the terminal period, a terminal value is calculated by dividing the last cash flow forecast by the difference between the discount rate and terminal growth rate. This equity value is then added to net debt to arrive at an enterprise value for the firm.
Another common method is relative valuation, which is often used when intrinsic analysis is not the appropriate method or to complement the DCF method. In relative valuation, a comparable peer group is determined for the target company based on factors such as the size of the target company, its industry, its location, and its product offerings. From these comparables (comps), data on a suitable multiple (a ratio, or a benchmark) is collected and used to value the target company rather than the company’s own cash flows. For example, a common multiple is enterprise value over EBITDA. These ratios across all comps would be weighted, before being multiplied by the company’s own EBITDA to arrive at its enterprise value.
The third method that we’ll go over today is precedent transaction analysis. In this method, a multiple is also used, though this method applies primarily to acquisition scenarios. After sourcing public data on similar acquisitions in the industry, a weighted average of multiple ratios based on selected acquisitions is taken. This involves you being familiar with the industry and market movements. Just like in relative valuations, you would need to look at factors such as the size of the company acquired, its industry, and the purpose of the transaction to determine suitable transactions that are comparable. However, be careful of taking this multiple as is, because market conditions could have changed since the transaction occurred. This method will typically result in a higher valuation than other methods due to the control premium the acquirer will pay for the target and the assumed synergies between the two after the transaction.
These are just a few common valuation methods, but there are much more that could be applied in the industry, for different purposes. Hopefully that has provided you with an overview of some tools used in the industry, and piqued your interest in corporate finance!
Disclaimer: This content has been prepared by F3 for the sole purpose of education and is not intended to be financial advice. For financial planning advice, you should consider your personal situation and always seek professional guidance.
