Valuation: Popular Methods (Part 2)

In this 2-part series, we will walk you through the importance and process of valuations.

In the first part, you learned what valuation is and why it is important. In part 2, we will give you a brief overview of two of the most popular methods used to value a company.

Methods of Valuation

Merchant bankers employ a host of different methods to value companies. Two of the most popular valuation methods are Discounted Cash Flow (DCF) and the Market Approach.

Discounted Cash Flow:

Discounted Cash Flow or DCF is a method used to evaluate how attractive an investment opportunity. The opportunity is considered a good one if the DCF analysis results in a higher value than the cost of the investment.

In order to arrive at the present value using DCF, there are 2 steps:

1. The future free cash flow projections are calculated; and
2. They are discounted using the Weighted Average Cost of Capital (WACC).

Step 1:

There are many ways to calculate free cash flow projections but a popular method of doing so is to use the following formula:

Free Cash Flow Projections: (operating profit + depreciation + amortization of goodwill) – (capital expenditures + cash taxes + change in working capital)

Once the free cash flows for 3-5 years have been projected, the WACC needs to be calculated.

Step 2:

WACC is applied as the discount rate for DCF analysis.

To determine WACC, the firm’s cost of capital is calculated by proportionately weighing each category of capital, including equity shares, preference shares, debentures and other forms of long-term debt. WACC and valuation are inversely proportional with an increase in the WACC implying a decrease in valuation.

The method for calculating WACC can be expressed in the following formula:

{(Value of equity/ total equity and debt) * cost of equity} + {(Value of debt/ total equity and debt) * cost of debt * (1- company tax rate)}

Calculating DCF:

To calculate DCF, use the following formula:

CF₁ / (1+k) + CF₂ / (1+k)² +CF_n / (1+k)ⁿ

CF_n = cash flow in year n

k= WACC rate

While DCF is a popular and powerful model, it has certain shortcomings. For example, an unexpected event can immediately make a DCF model redundant. Further, the DCF model focuses on long-term investments and is best avoided for short-term models.

The Market Approach

In the market approach, the value of assets is determined based on the net asset value. It can be used to calculate the value of ownership interest in a business or an intangible asset.

The merchant banker will study the fair market value of all the company’s assets and its total liabilities. The merchant banker will also determine which assets and liabilities to include in the calculation and how to assign a value to them.

Simply looking at its balance sheet is not enough to determine the assets and liabilities of a company since some assets like proprietary processes or products developed internally are intangible assets which will need to be assigned a value.

However, a merchant banker will begin by using information on the balance sheet and recasting historic value of assets at their current value. Each asset of the company is assigned a current fair value based on the market. Liabilities, on the other hand, are typically already stated at their current value.

In order to determine the market value of the company, the current fair value of all the assets are added up and the total liabilities are subtracted from them.

Conclusion

Valuation of your company is important and so is the method used to arrive at the valuation. This is where a merchant banker comes in. Based on your business model, they will choose the best method to use to value your company and its assets.

We have a great track record for carrying on valuations in a fair manner. Start making better decisions and schedule an appointment with our team to assess your valuation needs.

Image credit: CC BY-SA 3.0 Nick Youngson