How to Value a Company | Best Valuation Methods

Summary

In this video, Kenji explains three primary methods for valuing a company: the market-based multiples approach, the discounted cash flow (DCF), and the cost approach. Each method is examined in detail, with Kenji highlighting their pros, cons, and practical applications. He also discusses the concept of a 'football field' valuation chart, which combines these methods to offer a range rather than a single valuation figure. Throughout, Kenji emphasizes the importance of using these approaches in different contexts, whether for acquiring a company, investing, or valuing other types of assets.

Takeaways

• 😀 The video explains the importance of company valuation in business decisions like acquisitions and investments.
• 😀 There are three main methods for valuing a company: multiples-based approach, discounted cash flow (DCF), and cost approach.
• 😀 The multiples-based approach uses financial ratios (like P/E, EV/EBITDA) to compare a company to others in the market.
• 😀 One challenge of the multiples-based approach is finding comparable companies, especially for firms without earnings.
• 😀 The discounted cash flow (DCF) method focuses on the company’s projected future cash flows, adjusted for time value.
• 😀 DCF requires assumptions about future growth and a chosen discount rate, making it highly sensitive to changes in these factors.
• 😀 The cost approach values a company based on the cost to replace its assets, but it is less relevant for intangible assets like software.
• 😀 Each valuation method has strengths and weaknesses, so combining methods can provide a more balanced result.
• 😀 The Football Field Valuation is a chart that displays the results of different valuation methods, giving a range of values instead of a single number.
• 😀 Valuation is an art as much as it is a science, with a significant reliance on the analyst's judgment and assumptions.
• 😀 In practice, analysts often use a combination of methods to derive a company’s value, considering the limitations of each individual approach.

Q & A

What are the three main methods for valuing a company?

The three main methods for valuing a company are the multiples-based approach (market-based approach), the discounted cash flow (DCF) method, and the cost approach (also called the replacement cost approach).

What is the multiples-based approach to company valuation?

The multiples-based approach involves comparing the company's value relative to other similar companies in the market. Common multiples include price-to-earnings (P/E), enterprise value over sales, and enterprise value over EBITDA (earnings before interest, tax, depreciation, and amortization).

What is a P/E ratio and how is it used in valuation?

The P/E ratio is the price per share divided by the earnings per share. It is used to value a company by comparing its share price relative to its earnings, often alongside similar companies in the same industry.

What are some potential problems with using the P/E ratio for valuation?

The P/E ratio may not be applicable if the company has no earnings or made a loss. In such cases, other ratios like enterprise value over sales or EBITDA are used instead. Additionally, using averages can be skewed by outliers, so a median might be more useful in some cases.

What does the discounted cash flow (DCF) method focus on?

The DCF method focuses on intrinsic valuation, which means it evaluates the company's internal financials, primarily its projected future cash flows, to determine its value.

Why is the time value of money important in the DCF method?

The time value of money indicates that a dollar today is worth more than a dollar in the future due to factors like inflation. Therefore, future cash flows need to be discounted back to their present value to accurately estimate the company's worth.

What is the terminal value in the DCF method?

The terminal value represents the company's value after the projection period (e.g., five years). It is calculated based on assumptions of the company's performance beyond that period and is included in the DCF calculation.

What are the two main methods for calculating the terminal value?

The two main methods for calculating terminal value are the perpetual growth method and the exit multiple method. These methods estimate the value of a company beyond the projection period.

What is the cost approach and where is it most commonly used?

The cost approach is based on determining the value of a company by assessing the cost to replace it with a new one. It is most commonly used in real estate and tangible asset valuations, such as manufacturing plants or houses.

What are some pros and cons of the multiples-based approach?

The multiples-based approach is intuitive and easy to apply, but finding similar companies to compare can be challenging. For example, it's difficult to compare large companies like Amazon to others due to differences in size, industry focus, or geography.

What are some advantages and disadvantages of the DCF method?

The DCF method is independent of market conditions, which is useful during economic downturns. However, it is time-consuming, heavily relies on assumptions, and can lead to flawed valuations if those assumptions are inaccurate.

What is the football field chart and how is it used in company valuation?

The football field chart is a visual representation that combines different valuation methods (multiples, DCF, and cost approach) to provide a range of possible company valuations. It helps analysts derive a valuation range rather than a specific number, which is useful when none of the methods is perfect on its own.

How do assumptions affect the DCF valuation?

Assumptions in the DCF method, such as growth rates, discount rates, and terminal value, play a critical role in the final valuation. If assumptions are overly optimistic or pessimistic, the valuation could be skewed, which is why different scenarios (base case, best case, worst case) are often considered.

What is the role of government regulation in the cost approach?

Government regulation can impact the cost approach by affecting the feasibility of replacing or rebuilding certain assets. For example, new regulations may prevent the construction of a new warehouse in a particular area, making the replacement cost less relevant.