Valuation Techniques Overview

Street Of Walls Investment Banking Technical Training

Investment banks perform two basic, critical functions for the global marketplace. First, investment
banks act as intermediaries between those entities that demand capital (corporations) and those that
supply it (investors). Companies mainly facilitate this through debt and equity offerings. Second,
investment banks advise corporations on mergers & acquisitions (M&A), restructurings, and other
major corporate actions. The majority of investment banks perform these two functions, although there
are boutique investment banks that specialize in only one of the two areas (usually advisory services
for corporate actions like M&A).
In providing these services, an investment bank must determine the value of a company. How does an
investment bank determine what a company is worth? In this guide you will find a detailed overview of
the valuation techniques used by investment bankers to facilitate these services that they provide.
In this chapter we will cover two primary topic areas:

How do bankers determine how much a company is worth in other words, what valuation
techniques are typically used?
What are the advantages and disadvantages of each valuation technique, and when should
which technique be used?

Valuation Techniques: Overview

While there are many different possible techniques to arrive at the value of a company a lot of which
are company, industry, or situation-specific there is a relatively small subset of generally accepted
valuation techniques that come into play quite frequently, in many different scenarios. We will describe
these methods in greater detail later in this training course:

Comparable Company Analysis (Public Comps): Evaluation other, similar companies

current valuation metrics, determined by market prices, and applying them to the company
being valued.
Discounted Cash Flow Analysis (DCF): Valuing a company by projecting its future cash
flows and then using the Net Present Value (NPV) method to value the firm.
Precedent Transaction Analysis (M&A Comps): Looking at historical prices for completed
M&A transactions involving similar companies to get a range of valuation multiples. This
analysis attempts to arrive at a control premium paid by an acquirer to have control of the
business.
Leverage Buyout Analysis (LBO): Valuing a company by assuming the acquisition of the
company via a leveraged buyout, which uses a significant amount of borrowed funds to fund
the purchase, and assuming a required rate of return for the purchasing entity.

These valuation techniques are easily the most commonly used, other than in valuations for specific,
niche industries such as oil & gas or metal mining (and even in those industries, the aforementioned
valuation techniques frequently come into play). Different parts of the investment bank will use these
core techniques for different needs in different circumstances. Frequently, however, more than one
technique will be used in a given situation to provide different valuation estimates, with the concept
being to triangulate a companys value by looking at it from multiple angles.
For example, M&A bankers are typically most interested in Transaction and Comparables valuation for
acquisition and divestiture. Equity Capital Markets (ECM) bankers underwrite company shares in the
public equity markets in advance of an initial public offering (IPO) or secondary offering, and thus rely
heavily on Comparables valuation. Financial sponsors and leveraged finance groups will almost
always value a company based upon leveraged buyout (LBO) transaction assumptions, but will also
look at others. Also, in many cases, all of these groups will employ some degree of DCF valuation
analysis. These different divisions of an investment bank may come up with similar valuation ranges
using some subset of the techniques given, but will approach this process often with entirely different
goals in mind.

Thus all of these techniques are used routinely by investment banks, and for a banking analyst, at
least some degree of familiarity with all of these techniques must be achieved in order for that analyst
to be considered proficient at his or her job.
When To Use Each Valuation Technique
All of the valuation techniques listed earlier should be practiced by a junior banker, but some may be
more applicable than others, given the group, the client, and the exact situation.
Comparable Company Analysis
The Comparable Company valuation technique is generally the easiest to perform. It requires that the
comparable companies have publicly traded securities, so that the value of the comparable companies
can be estimated properly. We will detail the calculation process for Comparable Company analysis
later in this guide.
The analysis is best used when a minority (small, or non-controlling) stake in a company is being
acquired or a new issuance of equity is being considered (this also does not cause a change in
control). In these cases there is no control premium, i.e., there is no value accrued by a change in
control, wherein a new entity ends up owning all (or at least the majority) of the voting interests in the
business, which allows the owner to control the company cleanly. With no change of control occurring,
Comparable Company analysis is usually the most relied-upon technique.
Discounted Cash Flow Analysis (DCF)
A DCF valuation attempts to get at the value of a company in the most direct manner possible: a
companys worth is equal to the current value of the cash it will generate in the future, and DCF is a
framework for attempting to calculate exactly that. In this respect, DCF is the most theoretically correct
of all of the valuation methods because it is the most precise.
However, this level of preciseness can be tricky. What DCFs gain in precision (giving an exact estimate
based on theory and computation), they often lose in accuracy (giving a true indicator of the exact
value of the company). DCFs are exceedingly difficult to get right in practice, because the involve
predicting future cash flows (and the value of them, as determined by the discount rate), and all such
predictions require assumptions. The father into the future we predict, the more difficult these
projections become. Any number of assumptions made in a DCF valuation can swing the value of the
company sometimes quite significantly. Therefore, DCF valuations are typically most useful and
reliable in a company with highly stable and predictable cash flows, such as an established Utility
company.
Because DCFs are so difficult to get perfect, they are typically used to supplement Comparable
Companies Analysis and Precedent Transaction Analysis.
Precedent Transaction Analysis
The Precedent Transaction valuation technique is also generally fairly easy to perform. It does require
that the specifics of a prior acquisition/divestiture deal are known (price per share, number of shares
acquired or spun off, amount of debt assumed, etc.), but this is usually the case if the target (acquired
company) had publicly traded instruments prior to the transaction. In some industries, however,
relatively few truly comparable M&A transactions have occurred (or the acquisitions were too small to
have publicized deal details), so the Precedent Transaction analysis maybe difficult to conduct.
If the buyer acquires a majority stake in a company (or similarly, when a controlling stake in a business
is divested), a Precedent Transaction analysis is almost always to perform. Why do we use Precedent
Transactions analysis in this scenario? Because when a majority stake is purchased, the buyer
assumers control of the acquired entity. By having control over the business, the buyer has more
flexibility and more options about how to create value for the business, with less interference from
other stakeholders. Therefore, when control is transferred, a control premium is typically paid.

Precedent Transactions are designed to attempt to ascertain the difference between the value of the
comparable companies acquired in the past before the transaction vs. after the transaction. (In other
words, the analyst determines the difference between the market value of the company before the
transaction is announced vs. the amount paid for the company in a control-transferring purchase.) This
difference represents the premium paid to acquire the controlling interest in the business. Thus when a
change of control is occurring, Precedent Transaction analysis should typically be one of the valuation
methods used.
We will detail the calculation process for Precedent Transaction analysis later in this guide.
Leveraged Buyout Analysis (LBO)
Another possible way to value a company is via LBO analysis. LBOs are typically used by financial
sponsors (private equity firms) who are looking to acquire companies inexpensively can be sold at a
profit in several years. In order to maximize returns from these investments, LBO firms generally try to
use as much borrowed capital (debt financing) as possible to fund the acquisition of the company,
thereby minimizing the amount of equity capital that the sponsor itself must invest (equity financing).
Assuming that the investment makes a profit, this debt leverage maximizes the return achieved for the
sponsors investors.
There are three possible approaches to take in running an LBO analysis for a target company:
1. Assume a minimum required return for the financial sponsor plus an appropriate debt/equity ratio,
and from this impute a company value.
2. Assume a minimum required return for the financial sponsor plus an appropriate company value,
and from this impute the required debt/equity ratio.
3. Assume an appropriate debt/equity ratio and company value, and from this compute the
investments expected return.
Usually the first analysis is performed by investment bankers. If the value of the company is unknown
(as is usually the case), the goal of the LBO exercise is to determine that value by assuming an
expected return for a private equity investor (typically 20-30%) and a feasible capital structure, and
from that, determining how much the company could be sold for (and thereby still allow the financial
sponsor to achieve that required return). If the expected sale price/value of the company is known (for
example, if a bid on the company has been proposed), then the primary goal an LBO analysis is to
determine the best possible returns scenario given that value. (Bankers will often use LBO analysis to
determine whether a higher valuation from private equity investors is possible, again using the first
analysis).
LBO analysis can be quite complex to perform, especially as the model gets more and more detailed.
For example, different assumptions about the capital structure can be made, with increasing layers of
refinement, to the point where each individual component of the capital structure is being modeled
over time with a host of tranche-specific assumptions and features. That said, a simple, standard LBO
model with generic, high-level assumptions could be put together fairly easily.
Unfortunately, LBO valuations can be highly subject to market conditions. In a poor market
environment (periods of low capital markets activity, high interest rates, and/or high credit spreads for
High Yield bond issuances), this type of transaction is difficult to use. Hence LBO investing is highly
cyclical depending upon market forces.
Valuation Technique Advantages and Disadvantages
Each valuation method naturally has its own set of advantages and disadvantages. Some are more
reliable and accurate, while others are easier to perform, for example. Additionally, some valuation
methods are specifically indicated in certain circumstances. Here are the main Pros and Cons of each
method:
Comparable Company Analysis

Pro: Market efficiency ensures that trading values for comparable companies serve as a
reasonably good indicator of value for the company being evaluated, provided that the
comparables are chose wisely. These comparables should reflect industry trends, business
risk, market growth, etc.
Pro: Values obtained tend to be most reliable as an indicator of value of the company
whenever a non-controlling (minority) investment scenario is being considered.
Con: No two companies are perfectly alike, and as such, their valuations generally should not
be identical either. Thus comparable valuation ratios are often an inexact match. Also, for
some companies (or any at all!) can be very challenging. As a result in Comparable
Companies analysis are always running the risk of comparing apples to oranges, never
being able to find a true comparables, or simply having an insufficient set of comparables
valuations from which to draw.
Con: Illiquid comparable stocks that are thinly traded or have a relatively small percentage of
floated stock might have a price that does not reflect the fundamental value of that company.

Discounted Cash Flow (DCF) Analysis

Pro: Theoretically the most sound method if one is very confident in the projections and
assumptions, because DCF values the individual cash streams (the actual source of the
companys value) directly.
Pro: DCF method is not heavily influenced by temporary market conditions or non-economic
factors.
Con: Valuation obtained is very sensitive to modeling assumptions particularly growth rate,
profit margin, and discount rate assumptions and as a result, different DCF analyses can
lead to wildly different valuations.
Con: DCF requires the forecasting of future performance, which is very subjective, and most
of the value of the company is usually derived from the terminal value, which is the set of
cash flows that occurs after the detailed projection period (and is therefore usually projected in
a very simple way).

Precedent Transaction/Premium Paid Analysis

Pro: Generally regarded as the best valuation tool for control-transferring transactions
because the previous transaction has validated the valuation (in other words, a precedent has
been established, whereby a previous buyer has actually paid the amount specified in the
precedent transaction).
Pro: Assuming that the required transaction data is available/public information, precedent
transactions are typically as easy analysis to perform.
Con: The valuation multiples found in prior transactions typically includes control premium and
synergy assumptions, which are not public knowledge and are often transaction-specific.
These assumptions are not always achievable by other market participants conducting a new
transaction.
Con: Precedent Transaction valuations are easily influenced by temporary market conditions,
which fluctuate over time. For example, a prior transaction might have been conducted in a
more favorable environment for debt or equity issuance.

Leveraged Buyout (LBO) Analysis

Pro: An excellent means to establish a floor valuation an LBO analysis will determine the
amount that a financial buyer (sponsor) would be willing to pay for the company, thereby
determining the value that a strategic bidder will have to exceed.
Pro: LBO valuation is realistic, as it does not require synergies to achieve (financial buyers
usually do not have synergy opportunities).
Con: Ignoring synergies could result in an underestimated valuation, particularly for a wellfitting strategic buyer.

Con: The valuation obtained is very sensitive to operating assumptions (growth rate, operating
working capital assumptions, profit margins, etc.) and financing cost assumptions (and thus
LBO valuation is dependent upon the quality of the prevailing financing market conditions).
Valuation Building Blocks: Company Value
In order to use the valuation techniques described above, it is important to understand a few core
building blocks of valuation. These concepts will be used in much more detail in later chapters of this
training course, wherein we will walk you though how to conduct these valuations in explicit detail.
There are three common, related terms used to describe the value of a company:

Enterprise Value: Represents the total value of a companys net operating assets. In other
words, Enterprise Value is the value of the entire company.
Market Value: Also known as Market Capitalization or Equity Value, market value
represents the dollar value of a companys issued shares of common equity. It is calculated by
multiplying shares outstanding by the current stock price.
Book Value: The accounting valuation of the equity. Book Value simply equals Total Assets
Total Liabilities. Book Value is often called liquidation value, because it represents the
expected value of a companys assets after they are used to pay off all existing liabilities. This
generally assumes, of course, that the company will be ceasing operations.

What is the difference between Book Value and Market Value?

Market Value is almost always larger than Book Value for three primary reasons:

Market Value includes future growth expectations while Book Value does not.
Market Value includes brand value and company intangible assets.
Market Value includes value accrued by the company historically through wise managerial
decision making, while Book Value generally does not.

In other words, Book Value is a value arrived at for a company by simply following the rules of
standard accounting based on a companys past transactions and operations, while Market Value
takes into account all information about a companys operations, including future expectations.
How do you calculate Market Value and Enterprise Value?
Market Value is calculated based on the number of shares outstanding multiplied by the companys
current stock price.
Enterprise Value represents the total value of the firm and is found by adding the Net Debt of a
company to Market Value, where Net Debt is simply the companys Debt outstanding minus excess
Cash on the companys balance sheet.
Why is cash subtracted out?
Cash is subtracted out of Enterprise Value because excess Cash is considered a non-operating asset.
For example, that Cash often could be used to pay down part of the companys debt immediately,
which reduces the Enterprise Value of the Company. (Note that the definition of excess cash is
somewhat loose, as it refers to cash that is not needed to conduct the operations of the business; a
simplifying assumption in most cases is to count all Cash as excess Cash.)
When should enterprise value be used?
Enterprise Value should be used for ratios and other calculations that measure the total return to all
capital holders (such as Revenue, Earnings Before Taxes (EBT); Earnings Before Interest and Tax
(EBIT); Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA); Net Operating Profit
After Tax; Operating Cash Flow; etc.), whereas Equity Value should be used for ratios that measure
the total return to shareholders (such as Earnings/Net Income).

Here are a couple of simple examples of how to calculate Enterprise Value based on information
available for a company:
Solving For Enterprise Value, Example 1:

Cash: $200
Debt: $400
Equity: $1,600

Enterprise Value = Market Value of Equity ($1,600) + Debt ($400) Cash ($200) = $1,800
Solving For Enterprise Value, Example 2:

Shares Outstanding: 1,000

Stock Price: $10
Debt: $5,000
Cash: $1,000

Enterprise Value = Market Value of Equity (1,000 x $10 = $10,000) + Debt ($5,000) Cash ($1,000) =
$14,000.