what's up everyone kenji here and in this video i thought i'd share the three main methods to value a company so firstly we'll look at the multiples based approach which is also known as the market-based approach secondly we'll look at the discounted cash flow also known as the dcf and then thirdly we look at the cost approach which is probably the least common of the three after that we look at the pros and cons of each because unfortunately none of them are actually perfect and then lastly we'll go over how to look at them all together with something that's known as the football field which is a chart that looks like this one here but before we get into it why on earth would you want to value a company well from a business point of view you might want to value company maybe because you're looking to acquire it or vice versa maybe you're looking to sell your own company or sell a department of your company and you want to know how much that's worth right so that's one reason you might want to value a company the second more individual reason might be because say i'm looking to buy apple shares and i want to know if i'm buying them at a good price if they're a bit too expensive or they're undervalued then i could make some money on that right so that's another reason why you might want to value a company and while i'm talking about valuing companies here the same three valuation methods also apply to valuing other things like what might be a piece of real estate what might be say a piece of software or even a department within a company right so they're really widespread you can use them across all sorts of assets so let's get into them the first approach we'll be looking at is a multiples based approach which is also known as market based and if you don't know what a multiple is it's basically a ratio right so it's one number over the other a typical multiple for instance could be the p e ratio price per share divided by earnings per share and in short it's about comparing what your company's worth relative to other similar companies in the market right when you think about it it's actually not that different to you say buying an apartment and seeing the price of the apartment relative to other apartments in the area with the ratio or the multiple being the price per square foot or the price per square meter right and some of the more common multiples in finance at least could be enterprise value over sales it could be price to earnings like i mentioned earlier enter enterprise value over ebitda which stands for earnings before interest tax depreciation and amortization i know it sounds a bit daunting but in short it's just another way to measure profitability so let's look at an example and let's say that we're trying to value company x using the pe multiple and like i mentioned earlier the p stands for the price per share whilst the e stands for the earnings per share and here basically you're going to want to look for companies firstly that are similar to yours right let's say company x is a tech company so you look in the market for other companies in the same industry in this case in tech let's say company x is primarily in europe so you want to look for similar companies that are primarily in europe as well and also you want to look at companies that are of similar sizes right you can't really compare a company that has 1 million in revenue to one that has one billion in revenue right and let's say that after doing some market research we come up with five different companies and not very creatively i've named them a b c d and e and so now we want to find the relevant data to compare them right so in this case we gotta find the price per share as well as the earnings per share for each of these companies so once we have that information noted we're now gonna be able to find the actual pe ratio for each of these five companies and with that we're then gonna take the average pe ratio for all the five in this case it's 7.9 and like i mentioned earlier we want a value company x and let's say that we know that company x has an earnings of three dollars so based on that you're gonna be able to do the three times the 7.9 and that's going to give you the share price in this case that's 23.55 and i do want to point out that this example is very simplified there's still a lot of flaws in it so for instance the pe ratio depends on earnings right the e down there means the earnings but what if the company doesn't have any earnings maybe they didn't make a profit last year then how can you do a p ratio and the answer is that you can the p ratio is not applicable in this case so you would have to use some other ratios as well that's why i mentioned earlier the enterprise value over sales for instance also in this case we use the average rate but sometimes the average isn't all that good and that's mainly because it accounts for outliers right so if one of the say five companies we picked has a very very high p ratio that means it's gonna bring the average absurdly high as well right instead you might want to use a median typically for finance professionals they use both the average and the median as well just in case there's any outliers where the median obviously doesn't account for them and i could go on with many of the other simplifications that i had to make but i don't want to make this video too long but if you'd like me to do a video just specifically on the multiples based approach do let me know in the comments if this one does well make sure you hit that like and that subscribe i will try to do a part two or something like that where i'll just cover this specific valuation method now the second approach is known as the dcf the discounted cash flow and this one's based on intrinsic valuation and you're probably wondering just like i did back in the day well what the hell's intrinsic mean and basically it just means that it focuses internally so inherently within the company as opposed to looking at external factors when we looked at the multiples based approach it focused on other companies right whilst when you look at the dcf intrinsically that means that it's focusing internally on the company's operation on its business on its cash flows and basically a dcf is about finding the value of the company today based on future projections of how much money it's going to make in the future and let's look at a simple example here let's say that based on past cash flow growth rates we think that company x will be able to have stable cash flows of 10 million up until year five okay so we have these cash flows for the next five years does that mean that we just add up those five years and that's going to give us a valuation and the answer is unfortunately no and that's because of this thing called the time value of money which you might be familiar with if you've taken some finance classes and it basically says that a dollar today is worth more than a dollar dollar in the future that's mainly because of things like inflation rate which is actually eroding the value of your money over time so instead we need to discount all these cash flows back to the present right hence why it's called a discounted cash flow after all and we'll do that using a discount rate so the formula is going to look something like this and it looks a bit daunting but to be honest it's really not that hard the cf up here is the cash flow whilst on the bottom you have the r which stands for the discount rate and those numbers there you see as well as the m stand for the number of periods in this case for us it's years right and let's say that the discount rate we want to use is five percent and so for year one that would be ten million over one plus five percent in year two that would be eleven million divided by one plus five percent squared because it's year two and then year 3 would be cubed and so on and so forth right and once you discount all of them back to the present and sum them all together that's how you will get evaluation in this case it would be 23.29 million now unfortunately i need to break some bad news and that's that it's quite simplified as a model right what about after those five years does the company just suddenly stop functioning probably not right there's probably gonna be some business beyond those five years that's basically calculated using what's called the terminal value which is essentially the value of the business after those five years and this is a big assumption right you're saying that after this five year period for the remaining life of the company which you don't even know how long it's gonna live for you're gonna value it at x amount and there's really two main ways to calculate the terminal value the first one is known as the perpetual growth method and the second one is known as the x and multiple method now i'm not going to get into them in this video just because i don't want it to get too long but i will leave a very good article which is actually how i learned this back in the day in the description as well also another simplification that i wanted to point out here is the discount rate in this case we said it was 5.5 i honestly made that number up it could have been any other number but in reality there's actually a way to calculate this and that's using the walk which stands for the weighted average cost of capital now it's this massive formula um it looks a bit daunting but to be honest it's a lot simpler than it looks and i'll leave an article on this formula in case you want to understand it and look further into it i don't really want to get into it in this video but like i said earlier if you want me to do a full in-depth on dcf as well do let me know in the comments if this video does well i will consider it of course so the third valuation approach i'm gonna be covering is known as the cost approach it's also sometimes called the replacement cost approach basically this one's very common in real estate not so much in corporate finance roles like what might be say investment banking or private equity in short it says that the value of the business should be the cost to replace it with an equivalent new one right so for example if your business just burned down say your factory burned down one day what would be the cost to create a new one just like that right that's basically how they would measure it and overall what it's saying is that if it would cost you say 10 million to replace that then you don't want to pay anything more than 10 million for the array so let's look at the formula for this and let's say that we're valuing a house so the formula would be the replacement cost which is basically the cost of the construction the architect and so on minus depreciation which is basically the wear down of the house over time right which is actually making it less valuable and then lastly you want to add the value of the land that it sits on now this approach works best for tangible things which are basically things that you can touch right think say a manufacturing plant a house or a cell tower for instance that's primarily because you know the cost of each thing quite well well on the other hand for something like say an intangible or something that you can't touch like what might be a software a specific algorithm you can't really replicate the cost in the same way because maybe you just had one genius founder that managed to make this algorithm that no one else can in that case it's not like you can pay somebody else to try doing right so the costs there are a bit blurred hence why it's a lot more common in real estate for instance now let's look at the pros and cons of each method and starting off with the multiples approach here among the big pros is that it's quite intuitive right it's easy to understand it's quite relatively easy to do and so that's one of the main pros about it now on the coin side it's really not that easy to find the similar companies to the one you're trying to value right let's say i'm trying to value amazon for instance there's really not that many companies that are all that similar of the same size same geography same e-commerce market and so on and so forth right like let's say we want to compare to walmart for instance another big retailer but walmart's not so focused on the e-commerce space it's more on physical stores and so it's not that easy to actually find good comparing companies now moving on to the dcf and the main pro here is that it's independent of the market right like i mentioned earlier it's about the intrinsic value so whatever the competitors are doing doesn't really matter and that's particularly good say for instance if you're in a recession most of your competitors are going to be really down right so if you use a multiple space valuation odds are your company is going to be very down as well right well for instance if you use a dcf that's going to be independent of how the market's doing and instead you really have a core view of whatever your business is looking like one of the big cons in the dcf is that it's hard to do right it's very time consuming so if you've ever been asked in an interview to do a evaluation on a company and you have the choice of doing a multiples approach versus a dcf you always want to pick the multiples approach just because it's going to make your life a lot easier right another big con here are the assumptions and it's heavily assumption-based right and so that means that you might be a bit too optimistic on your company you might be a bit too pessimistic on it and based on that you're going to have a flawed valuation right typically i will say though that for a dcf say in a professional setting there's usually going to have a lot of different case scenarios so for instance you'll have a base case which is what you normally expect the company to do you'll also have a best case so a very optimistic scenario say you think like it's going to grow a lot more you're going to expand into new countries and so on and so forth and then you'll have a worst case scenario like say i don't know you get sued a couple times and so on and so forth so based on those three you'll actually derive three different valuations and based on how you're feeling you're gonna go with one or the other lastly looking at the cost approach and the main pro here is that it's very easy to do right it's quite easy to understand but on the coin side the costs are actually not that easy to account for right maybe it cost you say um a hundred thousand to construct the house uh five years ago but now the market's been booming and so it's a lot more expensive to construct the house now things like that that maybe they're not that clear as you might expect right another con of the cost approach has to do with government permits right and specifically with regulation so for instance maybe you had a warehouse and that's been there for 20 years but now the new regulation says that you can't actually build anything in that area so now you can't really have a replacement cost anymore right because you can't build anything so that's where the model kind of might get flowed and as you've seen in this pros and cons analysis none of the three methods are actually perfect right they all have some flaws somewhere and that's why evaluation is mainly regarded as both an art and a science and this brings us nicely to the last point which is the football field valuation and like i mentioned earlier because none of the three methods are actually perfect what they do is they actually bundle them together in a graph looking like this so that you can kind of get a range based on that so it's called a football field because that's what it resembles right i do think it requires a bit of imagination but well i think the names there to stay also you can see that there's actually a 52-week high and low range as well and that's quite common to have in there which is basically the share price how it fluctuated throughout the 52 weeks so the the last year right so looking at apple for instance here you can find it's 52 week high and low range too overall though when it comes to valuation the analyst isn't actually looking for a specific number instead they're looking to derive a valuation range right and let me know in the comments if you'd like me to do a three-part series where i cover each of the three evaluation methods make it maybe i could make it excel based where i actually do a full case study of say apple or a big company like that and we try to value it together so that's all for this video i hope you found it useful and i'll catch you in the next one you