Four Key Valuation Methods in Investment Banking

Whether advising on mergers and acquisitions, initial public offerings, or other strategic transactions, investment bankers rely on a suite of valuation methodologies to arrive at a supportable price or value for a business.

While numerous approaches exist, four methods form the bedrock of most valuation analyses: Discounted Cash Flow, Comparable Company Analysis, Precedent Transaction Analysis, and Market Valuation.

1. Discounted Cash Flow (DCF) Analysis: The Intrinsic Value Approach

The DCF analysis is based on the principle that a company's value is the present value of its future cash flows. This method attempts to determine the intrinsic value of a company, independent of market sentiment or comparable transactions.

How it works:

1. Project Free Cash Flows: The first step is to forecast the unlevered free cash flows that the company is expected to generate over a explicit projection period, typically 5-10 years. This involves making assumptions about future revenues, operating expenses, capital expenditures, and changes in working capital.
2. Calculate the Terminal Value: Since it's impossible to forecast cash flows indefinitely, a terminal value is calculated to represent the value of the company beyond the explicit forecast period. This is often done using either a perpetuity growth model (assuming cash flows grow at a constant rate forever) or an exit multiple approach (applying a valuation multiple, such as EV/EBITDA, to the final year's projected financials).
3. Determine the Discount Rate: Future cash flows are discounted back to their present value using a discount rate. The most common discount rate used is the Weighted Average Cost of Capital (WACC), which represents the average required rate of return for all of the company's capital providers (both debt and equity), weighted by their respective proportions in the company's capital structure.
4. Sum the Present Values: The present value of the projected free cash flows during the explicit period is added to the present value of the terminal value to arrive at the company's enterprise value.
5. Calculate Equity Value: To arrive at the equity value (the value attributable to shareholders), net debt and other non-equity claims are subtracted from the enterprise value. Dividing the equity value by the number of outstanding shares gives the intrinsic value per share.

Pros: Considered a theoretically sound method as it's based on future cash flow generation; forces a deep understanding of the company's business drivers and assumptions.

Cons: Highly sensitive to assumptions made about future growth, margins, and the discount rate; can be challenging to forecast cash flows accurately, especially for early-stage or cyclical companies.

2. Comparable Company Analysis (Trading Comps): What are Similar Companies Worth?

Comparable Company Analysis, often referred to as Trading Comps, is a relative valuation method that compares the target company to publicly traded companies with similar business models, financial profiles, performance drivers, and risks. Extrinsic value approach.

The idea is that similar companies should trade at similar valuation multiples. By benchmarking a company's relative position within its competitive landscape, we can begin to form a view on valuation for that company.

How it works:

1. Identify Comparable Companies: A peer group of publicly traded companies that are similar to the target company is selected based on various criteria (business characteristics and financial profile).
   1. Calculate Equity Value (Share price * FDSO) and Enterprise Value (EV = Equity Value + Debt + Preferred Stock + NCI - Cash). EV shows the value of the company's core business assets to all investors.
2. Gather Financial Data: Relevant financial data for the comparable companies and the target company is collected from the three financial statements. Include the last three financial years and LTM (calculate using last year's actual + current YTD - prior YTD). If comparable companies do not share the same year-end, calendarization is needed to ensure apples-to-apples comparison.
   1. Calendarization is the process of adjusting a company's financial data to align with a consistent 12-month period, typically the calendar year or a common fiscal year for the entire comparable set.
3. Non-Recurring Items & Adjustments: Adjust the income statement for Non-GAAP Adjustments. These are non-recurring or one-off items. P&L statements often include items that are not reflective of the company's ongoing operations, making direct comparisons difficult. Therefore adjusting for these items provides a better assessment of a company's core operational profitability and financial health. Common examples include:
   1. Restructuring Charges
   2. Impairment Charges
   3. Gains or Losses on Asset Sales
   4. Legal Settlements and Significant Fines
   5. One-Time Tax Adjustments
   6. Extraordinary Items
   7. Stock Based Compensation
   8. Significant Inventory Write-Downs
4. Calculate Valuation Multiples: Key valuation multiples are calculated for each comparable company. Common multiples include:
   • Enterprise Value / Revenue (EV/Revenue) - for high growth/early-stage companies
   • Enterprise Value / EBITDA (EV/EBITDA) - most popular
   • Enterprise Value / EBIT (EV/EBIT)
   • Price / Earnings (P/E)
   • Price / Book (P/B)
5. Determine the Relevant Range: A range of valuation multiples is derived from the comparable companies (e.g., using the median, mean, high, low). Study similarities and differences in size, growth rates, margin, and leverage.
6. Apply Multiples to the Target Company: The selected range of multiples is applied to the target company's relevant financial metrics to arrive at a valuation range for the target.

Pros: Market-based, reflecting current market conditions and investor sentiment; relatively straightforward and easy to understand; good for valuing mature, publicly traded companies with a clear set of peers.

Cons: Finding truly comparable companies can be difficult; market fluctuations can impact multiples, potentially leading to inaccurate valuations; doesn't account for company-specific factors or control premiums.

For Private Companies: When valuing private companies using the trading comps method, it's essential to apply discounts to the multiples derived from publicly traded companies. Examples include:

• Discount for Lack of Marketability: Accounts for the illiquidity of private shares compared to their publicly traded counterparts. Finding a buyer for a private company, or a minority stake in one, can be a time-consuming and costly process.
• Discount for Lack of Control: May be applied if valuing a minority interest, reflecting the absence of decision-making power. Investors pay a premium for control.
• Discount for Size: Smaller private companies often face higher inherent risks compared to larger, more established public companies. These risks can include greater customer concentration, reliance on a few key employees, limited access to capital markets, less diversified product lines, and weaker management depth.

3. Precedent Transaction Analysis (Transaction Comps): What Have Buyers Paid Historically?

Precedent Transaction Analysis, also known as Deal or Transaction Comps, is another relative valuation method that looks at the multiples paid in past merger and acquisition transactions involving companies similar to the target. Extrinsic value approach.

This method reflects the prices that buyers were willing to pay to acquire entire companies, often including a control premium.

How it works:

1. Identify Comparable Transactions: A universe of past M&A transactions is identified based on industry, size of the target company, transaction date (more recent deals are generally more relevant e.g., last 3 years), and deal characteristics (e.g., distressed sale, strategic buyer).
2. Gather Transaction Data: Data on the selected transactions is collected, including the purchase price, estimated synergies and stock/cash split. For financials include the last two financial years and LTM (calculate using last year's actual + current YTD - prior YTD). Use fairness opinions, merger proxy statement, press releases for gathering data on the transaction.
3. Non-Recurring Items & Adjustments: Adjust the income statement for Non-GAAP Adjustments.
4. Calculate Transaction Multiples: Valuation multiples paid in each transaction are calculated, similar to Trading Comps. Transaction value is considered EV. Offer value is considered Equity Value. Also calculate the projected financials for FY1 and FY2 multiples. Common multiples include:
   1. Transaction Value / Revenue
   2. Transaction Value / EBITDA - most common
   3. Transaction Value / EBIT
   4. Offer Value / Net Income (P/E)
5. Determine the Relevant Range: A range of transaction multiples is derived from the comparable deals (e.g., using the median, mean, high, low).
   1. Control Premium: Precedent transactions generally imply a higher valuation multiple range than that of trading comps. One of the primary drivers is the control premium. This arises from the purchase of majority control (>50%) of an organization. This will be calculated for the share price before the announcement for 1 day, 30 days, and 90 days to the offer share price.
6. Apply Multiples to the Target Company: The selected range of multiples is applied to the target company's relevant financial metrics to arrive at a valuation range based on historical acquisition values.

Pros: Based on actual transactions, including control premiums; can be useful for valuing private companies where public comps are less relevant.

Cons: Historical transactions may not reflect current market conditions; finding truly comparable transactions can be challenging; details of past deals may not always be fully public; doesn't account for specific synergies or unique aspects of the current transaction.

4. Leveraged Buyout (LBO) Analysis: Valuing for a Financial Buyer

Leveraged Buyout (LBO) analysis is a valuation method used to determine the maximum price a financial sponsor, typically a private equity firm, could pay for a company while still achieving a required rate of return on their investment.

This method is returns-driven as it focuses on the internal rate of return (IRR) the financial buyer can expect.

How it works:

1. Determine Transaction Assumptions: This involves making assumptions about the purchase price, the capital structure of the deal (how much debt and equity will be used), interest rates on the debt, and transaction fees.
2. Project Financial Performance: Create a financial model to project the target company's income statement, balance sheet, and cash flow statement over a typical investment horizon (e.g., 7 years). This forecast should reflect potential operational improvements or synergies the financial buyer might implement.
3. Model Debt Repayment: Based on the projected cash flows and the debt structure, model how the company's debt will be repaid over the investment period.
4. Calculate Exit Value: At the end of the investment horizon, an exit value is estimated. This is typically done using an exit multiple applied to the final year's projected EBITDA.
5. Calculate Equity Return (IRR): Based on the initial equity investment, the cash flows to the equity holder during the investment period (e.g., dividends), and the equity proceeds from the exit, the IRR for the financial sponsor is calculated. The purchase price is then adjusted until the target IRR is achieved.

Pros: Provides a crucial perspective for transactions involving financial sponsors; highlights the impact of debt financing and operational improvements on returns; useful for understanding the feasibility of an LBO.

Cons: Highly sensitive to assumptions about the capital structure, debt terms, and exit multiple; focuses on the financial buyer's perspective and may not reflect strategic value to other types of buyers; dependent on projected financial performance and debt-servicing capabilities.

Bringing it all Together

Investment bankers rarely rely on just one valuation method. Instead, they typically use a combination of these approaches to create a valuation range.

Each method has its strengths and weaknesses, and the most appropriate method or combination of methods will depend on the specific circumstances of the company being valued, the purpose of the valuation, and the availability of reliable data.