Investment banks perform two basic, critical functions for the global marketplace. First, investment banks act as intermediaries between those entities that demand capital (e.g. corporations) and those that supply it (e.g. investors). This is mainly facilitated through debt and equity offerings by companies. Second, investment banks advise corporations on mergers & acquisitions (M&A), restructurings, and other major corporate actions. The majority of investment banks perform these two functions, although there are boutique investment banks that specialize in only one of the two areas (usually advisory services for corporate actions like M&A).
In providing these services, an investment bank must determine the value of a company. How does an investment bank determine what a company is worth? In this guide you will find a detailed overview of the valuation techniques used by investment bankers to facilitate these services that they provide.
In this chapter we will cover two primary topic areas:
- How do bankers determine how much a company is worth—in other words, what valuation techniques are typically used?
- What are the advantages and disadvantages of each valuation technique, and when should which technique be used?
Valuation Techniques: Overview
While there are many different possible techniques to arrive at the value of a company—a lot of which are company, industry, or situation-specific—there is a relatively small subset of generally accepted valuation techniques that come into play quite frequently, in many different scenarios. We will describe these methods in greater detail later in this training course:
- Comparable Company Analysis (Public Comps): Evaluating other, similar companies’ current valuation metrics, determined by market prices, and applying them to the company being valued.
- Discounted Cash Flow Analysis (DCF): Valuing a company by projecting its future cash flows and then using the Net Present Value (NPV) method to value the firm.
- Precedent Transaction Analysis (M&A Comps): Looking at historical prices for completed M&A transactions involving similar companies to get a range of valuation multiples. This analysis attempts to arrive at a “control premium” paid by an acquirer to have control of the business.
- Leverage Buyout/“Ability to Pay” Analysis (LBO): Valuing a company by assuming the acquisition of the company via a leveraged buyout, which uses a significant amount of borrowed funds to fund the purchase, and assuming a required rate of return for the purchasing entity.
These valuation techniques are easily the most commonly used, other than in valuations for specific, niche industries such as oil & gas or metal mining (and even in those industries, the aforementioned valuation techniques frequently come into play). Different parts of the investment bank will use these core techniques for different needs in different circumstances. Frequently, however, more than one technique will be used in a given situation to provide different valuation estimates, with the concept being to triangulate a company’s value by looking at it from multiple angels.
For example, M&A bankers are typically most interested in Transaction and Comparables valuation for acquisition and divestiture. Equity Capital Markets (ECM) bankers underwrite company shares in the public equity markets in advance of an initial public offering (IPO) or secondary offering, and thus rely heavily on Comparables valuation. Financial sponsors and leveraged finance groups will almost always value a company based upon leveraged buyout (LBO) transaction assumptions, but will also look at others. Also, in many cases, all of these groups will employ some degree of DCF valuation analysis. These different divisions of an investment bank may come up with similar valuation ranges using some subset of the techniques given, but will approach this process often with entirely different goals in mind.
Thus all of these techniques are used routinely by investment banks, and for a banking analyst, at least some degree of familiarity with all of these techniques must be achieved in order for that analyst to be considered proficient at his or her job.
When To Use Each Valuation Technique
All of the valuation techniques listed earlier should be practiced by a junior banker, but some may be more applicable than others, given the group, the client, and the exact situation.
Comparable Company Analysis
The Comparable Company valuation technique is generally the easiest to perform. It requires that the comparable companies have publicly traded securities, so that the value of the comparable companies can be estimated properly. We will detail the calculation process for Comparable Company analysis later in this guide.
The analysis is best used when a minority (small, or non-controlling) stake in a company is being acquired or a new issuance of equity is being considered (this also does not cause a change in control). In these cases there is no control premium, i.e., there is no value accrued by a change in control, wherein a new entity ends up owning all (or at least the majority) of the voting interests in the business, which allows the owner to control the company cleanly. With no change of control occurring, Comparable Company analysis is usually the most relied-upon technique.
Discounted Cash Flow Analysis (DCF)
A DCF valuation attempts to get at the value of a company in the most direct manner possible: a company’s worth is equal to the current value of the cash it will generate in the future, and DCF is a framework for attempting to calculate exactly that. In this respect, DCF is the most theoretically correct of all of the valuation methods because it is the most precise.
However, this level of preciseness can be tricky. What DCFs gain in precision (giving an exact estimate based on theory and computation), they often lose in accuracy (giving a true indicator of the exact value of the company). DCFs are exceedingly difficult to get right in practice, because they involve predicting future cash flows (and the value of them, as determined by the discount rate), and all such predictions require assumptions. The farther into the future we predict, the more difficult these projections become. Any number of assumptions made in a DCF valuation can swing the value of the company—sometimes quite significantly. Therefore, DCF valuations are typically most useful and reliable in a company with highly stable and predictable cash flows, such as an established Utility company.
Because DCFs are so difficult to “get perfect,” they are typically used to supplement Comparable Companies Analysis and Precedent Transaction Analysis (discussed next).
Precedent Transaction Analysis
The Precedent Transaction valuation technique is also generally fairly easy to perform. It does require that the specifics of a prior acquisition/divestiture deal are known (price per share, number of shares acquired or spun off, amount of debt assumed, etc.), but this is usually the case if the target (acquired company) had publicly traded instruments prior to the transaction. In some industries, however, relatively few truly comparable M&A transactions have occurred (or the acquisitions were too small to have publicized deal details), so the Precedent Transaction analysis maybe be difficult to conduct.
If the buyer acquires a majority stake in a company (or similarly, when a controlling stake in a business is divested), a Precedent Transaction analysis is almost always the theoretically correct Comparable Company analysis to perform. Why do we use Precedent Transactions analysis in this scenario? Because when a majority stake is purchased, the buyer assumes control of the acquired entity. By having control over the business, the buyer has more flexibility and more options about how to create value for the business, with less interference from other stakeholders. Therefore, when control is transferred, a control premium is typically paid.
Precedent Transactions are designed to attempt to ascertain the difference between the value of the comparable companies acquired in the past before the transaction vs. after the transaction. (In other words, the analyst determines the difference between the market value of the company before the transaction is announced vs. the amount paid for the company in a control-transferring purchase.) This difference represents the premium paid to acquire the controlling interest in the business. Thus when a change of control is occurring, Precedent Transaction analysis should typically be one of the valuation methods used.
We will detail the calculation process for Precedent Transaction analysis later in this guide.
Leverage Buyout Analysis (LBO)
Another possible way to value a company is via LBO analysis. LBOs are typically used by “financial sponsors” (private equity firms) who are looking to acquire companies inexpensively in the hopes that they can be sold at a profit in several years. In order to maximize returns from these investments, LBO firms generally try to use as much borrowed capital (debt financing) as possible to fund the acquisition of the company, thereby minimizing the amount of equity capital that the sponsor itself must invest (equity financing). Assuming that the investment makes a profit, this debt leverage maximizes the return achieved for the sponsors’ investors.
There are three possible approaches to take in running an LBO analysis for a target company:
- Assume a minimum required return for the financial sponsor plus an appropriate debt/equity ratio, and from this impute a company value.
- Assume a minimum required return for the financial sponsor plus an appropriate company value, and from this impute the required debt/equity ratio.
- Assume an appropriate debt/equity ratio and company value, and from this compute the investment’s expected return.
Usually the first analysis is performed by investment bankers. If the value of the company is unknown (as is usually the case), then the goal of the LBO exercise is to determine that value by assuming an expected return for a private equity investor (typically 20-30%) and a feasible capital structure, and from that, determining how much the company could be sold for (and thereby still allow the financial sponsor to achieve that required return). If the expected sale price/value of the company is known (for example, if a bid on the company has been proposed), then the primary goal of performing an LBO analysis is to determine the best possible returns scenario given that value. (Bankers will often use LBO analysis to determine whether a higher valuation from private equity investors is possible, again using the first analysis.)
LBO analysis can be quite complex to perform, especially as the model gets more and more detailed. For example, different assumptions about the capital structure can be made, with increasing layers of refinement, to the point where each individual component of the capital structure is being modeled over time with a host of tranche-specific assumptions and features. That said, a simple, standard LBO model with generic, high-level assumptions can be put together fairly easily.
Unfortunately, LBO valuations can be highly subject to market conditions. In a poor market environment (periods of low capital markets activity, high interest rates, and/or high credit spreads for High Yield bond issuances), this type of transaction is difficult to use. Hence LBO investing is highly cyclical depending upon market forces.
Check out our Private Equity Training Course for much more detail on conducting LBO analysis.
Valuation Technique Advantages and Disadvantages
Each valuation method naturally has its own set of advantages and disadvantages. Some are more reliable and accurate, while others are easier to perform, for example. Additionally, some valuation methods are specifically indicated in certain circumstances. Here are the main Pros and Cons of each method:
Comparable Company Analysis
- Pro: Market efficiency ensures that trading values for comparable companies serve as a reasonably good indicator of value for the company being evaluated, provided that the comparables are chosen wisely. These comparables should reflect industry trends, business risk, market growth, etc.
- Pro: Values obtained tend to be most reliable as an indicator of value of the company whenever a non-controlling (minority) investment scenario is being considered.
- Con: No two companies are perfectly alike, and as such, their valuations generally should not be identical either. Thus comparable valuation ratios are often an inexact match. Also, for some companies, finding a decent sample of comparables (or any at all!) can be very challenging. As a result in Comparable Companies analysis are always running the risk of “comparing apples to oranges,” never being able to find a true comparable, or simply having an insufficient set of comparable valuations from which to draw.
- Con: Illiquid comparable stocks that are thinly traded or have a relatively small percentage of floated stock might have a price that does not reflect the fundamental value of that company.
Discounted Cash Flow (DCF) Analysis
- Pro: Theoretically the most sound method if one is very confident in the projections and assumptions, because DCF values the individual cash streams (the actual source of the company’s value) directly.
- Pro: DCF method is not heavily influenced by temporary market conditions or non-economic factors.
- Con: Valuation obtained is very sensitive to modeling assumptions—particularly growth rate, profit margin, and discount rate assumptions—and as a result, different DCF analyses can lead to wildly different valuations.
- Con: DCF requires the forecasting of future performance, which is very subjective, and most of the value of the company is usually derived from the “terminal value,” which is the set of cash flows that occurs after the detailed projection period (and is therefore usually projected in a very simple way).
Precedent Transaction/Premium Paid Analysis
- Pro: Generally regarded as the best valuation tool for control-transferring transactions because the previous transaction has validated the valuation (in other words, a precedent has been established, whereby a previous buyer has actually paid the amount specified in the precedent transaction).
- Pro: Assuming that the required transaction data is available/public information, precedent transactions are typically an easy analysis to perform.
- Con: The valuation multiples found in prior transactions typically include control premium and synergy assumptions, which are not public knowledge and are often transaction-specific. These assumptions are not always achievable by other market participants conducting a new transaction.
- Con: Precedent Transaction valuations are easily influenced by temporary market conditions, which fluctuate over time. For example, a prior transaction might have been conducted in a more favorable environment for debt or equity issuance.
Leverage Buyout (LBO) Analysis
- Pro: An excellent means to establish a “floor” valuation—i.e., an LBO analysis will determine the amount that a financial buyer (sponsor) would be willing to pay for the company, thereby determining the value that a strategic bidder will have to exceed.
- Pro: LBO valuation is realistic, as it does not require synergies to achieve (financial buyers usually do not have synergy opportunities).
- Con: Ignoring synergies could result in an underestimated valuation, particularly for a well-fitting strategic buyer.
- Con: The valuation obtained is very sensitive to operating assumptions (growth rate, operating working capital assumptions, profit margins, etc.) and financing cost assumptions (and thus LBO valuation is dependent upon the quality of the prevailing financing market conditions).
Valuation Building Blocks: Company Value
In order to use the valuation techniques described above, it is important to understand a few core building blocks of valuation. These concepts will be used in much more detail in later chapters of this training course, wherein we will walk you through how to conduct these valuations in explicit detail.
There are three common, related terms used to describe the “value” of a company:
- Enterprise Value: Represents the total value of a company’s net operating assets. In other words, “Enterprise Value” is the value of the entire company.
- Market Value: Also known as “Market Capitalization” or “Equity Value,” market value represents the dollar value of a company’s issued shares of common equity. It is calculated by multiplying shares outstanding by the current stock price.
- Book Value: The accounting valuation of the equity. Book Value simply equals Total Assets – Total Liabilities. Book Value is often called “liquidation value,” because it represents the expected value of a company’s assets after they are used to pay off all existing liabilities. This generally assumes, of course, that the company will be ceasing operations.
What is the difference been Book Value and Market Value?
Market Value is almost always larger then Book Value for three primary reasons:
- Market Value includes future growth expectations while Book Value does not.
- Market Value includes brand value and company intangible assets.
- Market Value includes value accrued by the company historically through wise managerial decision making, while Book Value generally does not.
In other words, Book Value is a value arrived at for a company by simply following the rules of standard accounting based on a company’s past transactions and operations, while Market Value takes into account all information about a company’s operations, including future expectations.
How do you calculate Market Value and Enterprise Value?
Market Value is calculated based on the number of shares outstanding multiplied by the company’s current stock price.
Enterprise Value represents the total value of the firm and is found by adding the Net Debt of a company to Market Value, where Net Debt is simply the company’s Debt outstanding minus excess Cash on the company’s balance sheet.
Why is Cash subtracted out?
Cash is subtracted out of Enterprise Value because excess Cash is considered a non-operating asset. For example, that Cash often could be used to pay down part of the company’s debt immediately, which reduces the Enterprise Value of the Company. (Note that the definition of “excess cash” is somewhat loose, as it refers to cash that is not needed to conduct the operations of the business; a simplifying assumption in most cases is to count all Cash as excess Cash.)
When should Enterprise Value be used?
Enterprise Value should be used for ratios and other calculations that measure the total return to all capital holders (such as Revenue, Earnings Before Taxes (EBT); Earnings Before Interest and Tax (EBIT); Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA); Net Operating Profit After Tax; Operating Cash Flow; etc.), whereas Equity Value should be used for ratios that measure the total return to shareholders (such as Earnings/Net Income).
Here are a couple of simple examples of how to calculate Enterprise Value based on information available for a company:
Solving for Enterprise Value, Example 1:
- Cash: $200
- Debt: $400
- Equity: $1,600
Enterprise Value = Market Value of Equity ($1,600) + Debt ($400) – Cash ($200) = $1,800.
Solving for Enterprise Value, Example 2:
- Shares Out.: 1,000
- Stock Price: $10
- Debt: $5,000
- Cash: $1,000
Enterprise Value = Market Value of Equity (1,000 × $10 = $10,000) + Debt ($5,000) – Cash ($1,000) = $14,000.←Valuation: A Conceptual OverviewFinancial Statement Analysis→