The Finance Association – EPFL

Valuation Models : How to Value a Company

Stefano Ramella

Nov 2019 · 25 min read

Valuation Models are used to assess the worth of a given company : this is needed for IPO, Acquisition, Mergers. In this article, 3 methods are presented : Discounted Cash Flow Analysis, Comparable Companies Analysis and Precedent Transaction Analysis. Each of these methods can be thought as 5-steps process. 

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Overview

The three methods presented here are among the most commonly used among the finance professionals. They rest on different assumptions :

    • Discounted Cash Flow Analysis (DCF) : Discounted future free cash flow projections are a good estimate of the worth of the company
    • Comparable Companies Analysis (CCA) : Similar companies will have similar valuation multiples
    • Past Transaction Analysis (PTA) : Precedent transactions for similar companies are a good estimate of what the company would be worth in the case of an acquisition.

Discounted Cash Flow Analysis (DCF)


To perform a DCF, it is key to study and learn as much as possible about the target and the sector in order to avoid misguided assumptions and valuation distortions. This is easily done for public companies (availability of data), but more challenging for private companies.

    • If the company is public, data can be get from SEC filing, earnings call transcripts and investor presentations. Equity research reports add additional information on the financial performance estimates
    • If the comapy is private, company management is the primary source of data to provide materials containing basic business and financial information

 

Step 2 : Project Free Cash Flow

Free Cash Flow (FCF) is the cash generated by a company after paying all cash operating expenses and associated taxes, as well as the funding of capex and working capital, but prior to the payment of any interest expense. It can computed according to the following formula :

 

One should consider keep in mind the historical performance of the company as it provides valuable insight for developing defensible assumptions to project FCF : past growth, profit margins are usually a reliable indicator of future performance, especially for mature companies in noncyclical sectors. The Projection Period Length is often set to five years depending on its sector, stage of development, and the predictability of its financial performance.

 

Step 3 : Calculate the WACC

WACC (Weighted Average Cost of Capital) is the rate used to discount the target’s projected FCF and terminal value to the present : it represents the weighted average of the required return on the invested capital and can be thought of as an opportunity cost of capital or what an investor would expect to earn in an alternative investment with a similar risk profile.

The calculation of the WACC is performed by following these four steps :

1. Determine Target Capital Structure

    • Use comparables from public market to get a proxy of the optimal capital structure
    • The target capital structure is represented by debt-to-total capitalization

2. Estimate Cost of Debt

3. Estimate Cost of Equity

    • It is the required annual rate of return that a company’s equity investors expect to receive (including dividends)
    • CAPM ( Capital Asset Pricing Model ) : 
    • The risk-free rate is often estimated with T-Bills and T-Notes
    • The Market Premium can range from approximately 5% to 8%
    • To calculate Beta from the public market one should neutralize the effects of different capital structures “Unlevering the Betas” : 
    • Once the Unlevered Betas have been computed an average is computed
    • The beta is then relevered using the company’s target capital structure
    • CAPM is applied with the calculated Beta in order to obtain the cost of equity

 

 

The logic behind CCA is different from DCF. The approach is comparative and is based on the assumption that similar companies will have similar valuation multiples. The criteria to judge the similarity between companies are mainly based on the size and sector.

Note that the actual selection of the comparable companies should only begin once this research is completed.

It is important to consider the following points while screening for Comparable Companies : 

    • Various sources can be used to screen for potential comparable companies. Initially, the focus is on identifying companies with a similar business profile
    • Public companies typically discuss their primary competitors
    • Additional source for locating comparables is the proxy statement for a relatively recent M&A transaction in the sector as it contains excerpts from a fairness opinions
    • Sector knowledge and familiarity with the target from senior bankers could be the most valuable resource

Step 2 : Locate the Necessary Financial Information

The most common sources for public financial data are SEC filings, earnings announcement, investor presentations, equity research reports, consensus estimates and press releases available via Bloomberg. Here is a summary of financial data source that can be used :

 Several metrics and ratios are to be used here : 

    • Size
    • Profitability
      • Gross Profit Margin
      • EBITDA Margin
      • Ebit Margin
      • Net Income Margin
    • Growth Profile
      • Look at historical and estimated future growth rates as well as compound annual growth rates (CAGRs)
    • Return on Investment
      • ROIC
      • ROE
      • ROA
    • Credit Profile
      • Leverage
      • Interest Coverage Ratio

 

The mean and medians of the most relevant multiple for the sector are used (typically EV/EBITDA or P/E), then the low and high multiples of the comparables universe are used as floor and ceiling to provide further guidance :

 

 

Precedent Transaction Analysis (PTA)

Overview of PTA

PTA logic holds the same logic as CCA, that is relative valuation of a company based on comparison with similar players. The main difference with CCA is that one estimates the value of the company based on previous transactions such as the price paid for similar players. As PTA and CCA are very similar, only an overview of PTA is presented below :

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Written by Stefano Ramella

 

 

 

 

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