Investors use two related approaches to value companies. These two approaches are intrinsic valuation and relative valuation. Intrinsic valuation equates value to the present value of future expected cash flows. Relative valuation uses adjusted valuation multiples of peer companies to value a given company.
Theoretically, both approaches should yield the same value because the intrinsic valuation approach provides the theoretical foundation for the relative valuation approach. That is, forecasts of valuation drivers drive future cash flows, which then determine intrinsic value. These same forecasts should drive the valuation multiples used in the relative valuation approach. However, in practice, the two approaches can yield different values because assumptions made in the intrinsic value approach may differ from market expectations.
Professional investors use both approaches to compute value and then compare the answers. An analysis of the causes of the difference between two values helps investors get better insights what drives the value of a company and how their expectations of the company’s future differ from market expectations.
We offer consulting in the following steps of relative valuation:
Picking peer companies
- Defining industry attributes
- Matching companies on size, growth, margins, asset intensity, and risk
Computing equity value and enterprise value
- Incorporating dilutive securities such as options, restricted stock, convertible debt, convertible preferred, warrants
- Incorporating tax effects of dilutive securities
- Unlevering equity value to arrive at enterprise value: Separating debt from operating liabilities: Determining the treatment of pension and healthcare liabilities, debt of finance subsidiaries, receivables of finance subsidiaries, interest-bearing receivables
Identify and measure value drivers such as earnings; compute multiples for peer companies
- Determining the appropriate value drivers: Revenues, EBITDA, EBIT, Net income
- Adjusting the value drivers to remove non-recurring items
- Understanding the rationale behind the use of non-GAAP numbers as value drivers
Identify and adjust for differences between the selected company and its peers
- Adjust for differences in business strategy, size, growth, margins, asset intensity, and risk between the company to be valued and its peers
Pick a value in the range after subjective adjustments
- Arrive at a range of values for the selected company based on the company's value drivers and the adjusted multiples of its peers
We offer consulting regarding the following steps of intrinsic valuation:
Identify cash flow drivers
- Cash flows equal profit minus the change in the level investment needed to sustain growth. Conceptually, the four drivers of cash flows are size, growth, margins, and net asset intensity (the inverse of net asset turnover). Size is commonly measured by sales and therefore growth is measured by sales growth. Sales, sales growth, and forecasted margins are used to project the income statement while the net asset intensity is used to project the non-cash assets and non-debt liabilities. More detailed drivers such as market size, market share, product pricing, and production volumes are analyzed to arrive at the four drivers mentioned above.
Analyze cash flow drivers
- “You analyze what you want to forecast because history tends to repeat itself.” Although there is no guarantee that a company’s future will be exactly like its past, it is still useful to examine its track record as a starting point.
Forecast cash flows
- After examining the historical record, one needs to make subjective assessments of the future forecast cash flows drivers.
Forecast terminal value
- Most DCF models forecast cash flows explicitly for a period of 3-5 years. At the end of the forecast horizon, they assume that the terminal value is a multiple of EBITDA or EBIT or EBIT*(1-t) or unlevered cash flows. In theory, terminal value equals the present value of cash flows beyond the explicit forecast horizon. Therefore, computing terminal value requires long-term forecasts of cash flows. To be accurate, one should forecast cash flows until they reach perpetual growth and then use a short-cut formula provided by the Gordon Growth model to arrive at terminal value. The Gordon growth model requires an estimate of perpetual growth and discount rate.
Forecast discount rate
- To compute present values, one needs a discount rate. The discount rate reflects the systematic risk of the unlevered cash flows of the company and as such does not depend on the capital structure. However, if one wants to incorporate the fact that interest is tax deductible by companies but dividends are not tax deductible and that interest income to investors is taxed at different rates than capital gains and dividend income from equities, then one needs to also consider the target capital structure while arriving at the weighted average cost of capital.
Compute present value
- Value equals the present of cash flows until terminal value plus the present value of terminal value. This is a straightforward calculation that is easy to implement using spreadsheets.
Run sensitivity tests
- These tests highlight the impact of critical assumptions. Usually the discount rate, growth rate, and terminal value turn out to be the critical assumptions.