Three Methods to Value a Company

Introduction

• Presenter: Kenji
• Topics Covered: Key methods to value a company
  • Multiples-based approach (market-based approach)
  • Discounted Cash Flow (DCF)
  • Cost approach
• Purpose of Valuation:
  • Business reasons - acquisition, or selling a company/department.
  • Personal reasons - evaluating if company shares are undervalued, overvalued, or fairly priced.
  • Applicable not only to companies but also to real estate, software, or departments within a company.

Multiples-Based Approach (Market-Based Approach)

• What is a Multiple?
  • A ratio: one number over another.
• Examples of Multiples:
  • P/E Ratio (Price per Share / Earnings per Share)
  • Enterprise Value / Sales
  • Enterprise Value / EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization)
• Steps in Multiples-Based Valuation: Example
  • Find companies similar to the one being valued (industry, geography, size).
  • Collect relevant data on P/E ratios of these companies.
  • Calculate the average P/E ratio.
  • Multiply company's earnings by the average P/E ratio to find the share price.
• Limitations:
  • Not applicable if the company has no earnings.
  • Outliers can affect the average P/E ratio.
  • Alternative: use median P/E ratio.
  • Over-simplified (real-life scenarios require considering more variables).

Discounted Cash Flow (DCF)

• Intrinsic Valuation: Focuses internally on the company's operations, business, and cash flows.
• Principle: Value the company today based on future cash flow projections.
• Steps in DCF Valuation: Example
  • Estimate future cash flows (e.g., $10 million/year for 5 years).
  • Apply the time value of money - discount future cash flows to their present value.
  • Formula: Present Value = Cash Flow / (1 + discount rate)^number of periods.
  • Example: Using a 5% discount rate to arrive at a valuation after summing discounted cash flows.
• Complexities & Assumptions:
  • Estimating terminal value (beyond the projected period).
  • Calculating the discount rate (Weighted Average Cost of Capital - WACC).
  • Tandem process requiring precise and realistic assumptions.
  • Best/Worst case scenarios.

Cost Approach (Replacement Cost Approach)

• Principle: Value of a business equals the cost to replace it with a new equivalent one.
• Application: Common in real estate valuation.
• Example: Valuing a house.
  • Formula: Replacement cost (construction cost) - depreciation + value of the land.
• Limitations:
  • Difficult to apply for intangible assets like software.
  • Market and regulatory changes affecting cost estimates.

Pros and Cons of Each Method

Multiples-Based Approach

• Pros:
  • Intuitive and easy to understand.
  • Relatively easy to execute.
• Cons:
  • Finding comparable companies can be difficult.
  • Less applicable for unique companies.

Discounted Cash Flow (DCF)

• Pros:
  • Independent of market conditions.
  • Provides a core view of the company's potential.
• Cons:
  • Time-consuming and complex.
  • Heavily assumption-based, leading to biased results.

Cost Approach

• Pros:
  • Easy to apply for tangible assets.
• Cons:
  • Hard to account for specific costs and regulatory impacts.
  • Less effective for intangible assets.

Football Field Valuation

• Combination of Methods: Bundling various approaches to derive a valuation range.
• Format: Chart that provides a visual range rather than a specific number to account for different methodologies.
• Additional Metrics: Can include 52-week high and low ranges.

Conclusion

• Evaluation as Both Art and Science: No single method is perfect; a combination gives a more reliable range.
• Further Learning: Request for detailed tutorials on each method.