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Valuation
November 6, 2020
What is Valuation?
Valuation is intrinsic to the world of corporate finance. There are many situations in which business valuation is a central component. These include:
- Buy-side M&A
- Sell-side M&A
- Fairness opinions
- IPOs
- Equity research
- Levered value
Key Learning Points
- Valuation is vital in the corporate finance world and helps analysts in many contexts including M&A, IPOs, Equity research and levered value
- Valuation methodologies can be split into market-based (relative valuation) and intrinsic (fundamental analysis)
- Both private and public companies can be valued with either methodology, however, inside information is harder to obtain for private companies
- Trading comparables use the traded share price for a business compared against a similar company to that being valued
- Transaction comparables compare the unaffected share price of a company to the price paid in an M&A transaction to understand the size of the premium buyers are willing to pay to acquire a controlling stake in a business
- Discounted cash analysis (DCF) calculates the value of a business as the present value of the free cash flows it is expected to generate into the future
Valuation Methodologies
There are also many different valuation methodologies used, some of which are market-based (relative valuation) and some based on fundamental analysis (absolute valuation). All valuation methodologies can be used to value public and private companies.
Market-based valuation methodologies include trading and transaction comparables. These business valuation techniques start with market prices for a peer group of businesses or transactions. A benchmark is established and used to arrive at a relative valuation for the business being valued. Trading comparables (comparable companies or trading comps) use the traded share price for businesses which are judged to be similar to that being valued.
Transaction comparables (precedent transactions or deal comps) use prices paid for similar businesses in an acquisition of a controlling stake. Because they use a market price as the starting point, they inform as to the market’s view of the valuation.
The selection of the peer group of comparables involves a high degree of judgment and can have a significant influence on the valuation. The value derived from transaction comps is likely to be higher than that from trading comps because it includes the premium generally paid to acquire control.
Discounted Cash Flow Analysis
The most commonly used cash flow based valuation tool is discounted cash flow or DCF. This is based on the principle that the value of a business can be derived from the present value of its future cash flows. DCF analysis required numerous assumptions about financial performance, such as growth rates, margins, and investment levels and as a consequence is a fundamental valuation technique. The resultant valuation is called intrinsic value. DCF analysis can be done on a standalone basis or include the changes and effects of a potential acquisition (such as synergies).
DCF can serve as an important counterpoint to market-based valuation techniques and can be critical in value establishment such as when there are few or no “pure play” comparable businesses or transactions.