There are three main approaches to company valuation: comparable companies analysis, precedent transactions analysis and discounted cash ﬂow (DCF) analysis.
Comparable companies analysis
Comparable companies analysis is based on the idea that similar companies share key financial and operational characteristics, risks and performance drivers. Comparable companies analysis involves selecting peer companies and then compare them and the target based on various financial ratios and key performance indicators. Then, trading multiples are calculated for the peer companies and applied to the target’s relevant financial indicators to come up with a valuation range for the target.
Comparable companies analysis step-by-step
- Make a list of comparable companies. At the beginning, an analyst reviews as many potential comparable companies as possible. Then, the long list is narrowed down o the closest comparables.
- Find the required financial information. Once the closest comparables are determined, the analyst finds the financial information required to analyze the peer group companies and calculate key financial ratios and trading multiples.
- Calculate key ratios, performance indicators and trading multiples. This step involves calculating such measures as enterprise value (EV) and equity value, EBITDA and net income as well as other ratios measuring profitability, growth, and returns.
- Benchmark the comparable companies. Financial ratios and trading multiples for the comparable companies and the target are laid out in a spreadsheet form for comparison and analysis. The analysis of the similarities and discrepancies among peer group companies helps to establish the target’s relative ranking.
- Find out valuation range. A valuation range for the target is derived from the trading multiples of the peer group companies (comparable companies) applied to the target’s relevant financial metrics.
Precedent transactions analysis
Precedent transactions analysis is a multiples-based method of determining a sale price range for a target company. It is based on multiples paid for similar to the target companies in previous M&A deals. The selection of a suitable universe of comparable mergers or/and acquisitions is the essential part of the precedent transactions analysis. The most recent transactions (2-3 years) are the most relevant, since they most likely took place under similar macroeconomic environment and market conditions.
Precedent transactions analysis step-by-step
- Select the comparable acquisitions (mergers). Determining precedent transactions starts from searching through M&A databases and examining the M&A history of the comparable companies. An analyst should learn as much as possible about the specifics of each M&A deal and dynamics of each transaction.
- Find the required financial information. This step may be difficult because acquirers prefer to hide deal-related financial information for competitive reasons. Therefore, determining M&A transaction multiples are sometimes impossible.
- Calculate key ratios, performance indicators and transaction multiples. After the relevant financial information has been found, the analyst should analyze each selected transaction in Excel spreadsheet. This includes entering the deal-related data into an input page, and calculating relevant multiples for each transaction.
- Benchmark the comparable acquisitions (mergers). This step involves examining the key financial indicators, ratios and other relevant information for the acquired companies and calculating the transaction multiples for each selected acquisition.
- Find out valuation range. An implied valuation range for the target is derived from the multiples of the precedent transactions. As with other valuation methods, the target’s valuation range is checked and compared to the output from other valuation techniques.
Discounted Cash Flow Analysis
Discounted cash flow analysis (DCF) is a fundamental valuation methodology. It is based on the idea that the value of a company can be determined from the present value of its projected free cash flow (FCF). The DCF is a broadly used methodology for valuation for M&A transactions, IPOs, and investment decisions. A DCF can be employed as a check on the comparable companies and precedent transactions methods. In addition, a DCF is used when there are no peer companies or comparable transactions. In this method, company’s free cash flow is projected for a period of five to ten years. Then, the projected free cash flow and terminal value are discounted at the weighted average cost of capital (WACC) and summed to determine an enterprise value (EV).
Discounted cash flow (DCF) analysis step-by-step
- Determine key performance drivers. The first step is to learn as much as possible about the company and its industry and to determine the key performance drivers such as revenue growth, profitability, and free cash flow generation.
- Forecast free cash flow. The forecasting of the company’s free cash flow is the essential part of DCF analysis. The company’s FCF projection depends on underlying assumptions about its future financial performance (revenue growth rates, profit margins, capital expenditures (CAPEX), and working capital needs).
- Calculate WACC (Weighted Average Cost of Capital). WACC is commonly referred to as a “discount rate” or “cost of capital” and is heavily dependent on the target’s capital structure.
- Determine terminal value. In the DCF method, a terminal value is used to measure the remaining value of the company after the forecast period of 5–10 years. The target’s terminal value can be calculated with the exit multiple method and the perpetuity growth method.
- Determine valuation. The company’s forecast free cash flow and terminal value are discounted to determine the present value of future cash flows and summed to calculate the target’s EV (enterprise value). Since a DCF analysis incorporates numerous assumptions about various performance drivers, a sensitivity analysis is performed to produce a valuation range by varying key inputs.