Valuation Methods

Summary

This script delves into the three primary methods of business valuation: the cost approach, which considers initial and replacement costs; the market approach, using comparable companies and precedent transactions; and the discounted cash flow (DCF) analysis, an intrinsic valuation forecasting future performance and discounting it to present value. The focus is on understanding these methods to estimate a company's value, highlighting the importance of considering a range of valuations to determine the most accurate business worth.

Takeaways

• 📊 There are three main approaches to professional business valuation: cost approach, market approach, and discounted cash flow analysis.
• 🏭 The cost approach considers both the original cost to build an asset and its current replacement cost, accounting for inflation and technological changes.
• 🔍 The market approach uses relative valuation, comparing the company to similar publicly traded companies or past mergers and acquisitions.
• 📈 In the market approach, valuation ratios such as revenue, EBIT or earnings can be used to estimate the value of the company being assessed.
• 💰 Precedent transactions include takeover premiums, reflecting the higher price paid for control in acquisitions.
• 🔮 Discounted cash flow (DCF) analysis is an intrinsic valuation method that forecasts a company's future performance and discounts it back to present value using a discount rate.
• ⏳ DCF analysis typically projects a company's cash flows for about five years and then applies a terminal value based on perpetual growth.
• 💼 The weighted average cost of capital is commonly used as the discount rate in DCF analysis to determine the net present value of a business.
• 📊 A football field chart is a visual tool used by finance professionals to summarize and compare different valuation methods and stock prices over time.
• 📉 The chart includes relative valuation techniques like comps and precedent transactions, intrinsic value ranges from DCF, and the 52-week high and low stock prices.
• 🤔 The role of a valuation analyst is to weigh different valuation methods, consider a range of values, and determine the most reasonable business value within that range.

Q & A

What are the three main approaches to professional business valuation mentioned in the script?

The three main approaches to professional business valuation are the cost approach, the market approach, and the discounted cash flow (DCF) analysis.

What are the two methods used in the cost approach for business valuation?

The two methods used in the cost approach are the original cost to build something and the replacement cost, which takes into account inflation and changes in technology.

How does the cost approach serve as an opportunity cost in business valuation?

The cost approach serves as an opportunity cost by allowing a potential acquirer to compare the cost of building a similar business from scratch versus acquiring an already operating business.

What is the market approach in business valuation and how does it work?

The market approach is a form of relative valuation that involves comparing the business being valued with other companies or assets. It uses comparable companies and precedent transactions to determine the value of the business based on market data.

How are comparable companies used in the market approach for business valuation?

Comparable companies are publicly traded companies that are similar to the one being valued. Their share prices and various financial ratios are used to estimate the value of the business being evaluated.

What are precedent transactions and how do they factor into the market approach?

Precedent transactions refer to past mergers and acquisitions. They are used to understand how much an acquiring company paid for a business, including any takeover premiums, to help determine the value of the business being evaluated.

What is the discounted cash flow (DCF) analysis and why is it considered an intrinsic form of evaluation?

The discounted cash flow analysis is an intrinsic form of evaluation that forecasts the future performance of a business and discounts those cash flows back to the present value using a discount rate, typically the weighted average cost of capital. It focuses on the company's internal performance rather than external market conditions.

How does the terminal value in DCF analysis contribute to the overall valuation?

The terminal value in DCF analysis represents the value of the business beyond the forecast period, often assuming a sale or perpetual growth rate. It is an important component as it captures the long-term value of the business.

What is the purpose of using a football field chart in summarizing business valuation methods?

A football field chart is used to visually summarize and compare different valuation methods, providing a comprehensive overview of the value ranges derived from each method, and helping analysts to triangulate and determine a reasonable value for the business.

How do valuation professionals use the information from a football field chart to determine the business's value?

Valuation professionals review the ranges of values derived from comparable company analysis, precedent transactions, and DCF analysis. They weigh the different methods, consider the upside and downside scenarios, and use their expertise to estimate where the actual value of the business lies within the range.

What is the significance of the 52-week high and low trading prices on a football field chart?

The 52-week high and low trading prices on a football field chart represent the market's observed valuation of a publicly traded company over the past year. These prices provide context and a reference point for the valuation analyst to compare with the intrinsic and relative valuation methods.