Financials – Company Valuation Methods

One of the things we want to examine is the methods we use to assess company valuation. Typically, we employ three main approaches: discounted cash flow analysis, comparable company analysis, and precedent transactions.

In this process, we consider the capital structure, which is the mix of equity and debt that constitutes the firm. Various factors influence this structure, but our primary focus is on the risk the company incurs in terms of meeting interest payments and other obligations.

We also analyse Enterprise Value, which represents the total value of the firm, including both equity and debt, as well as equity value, which is the value of the firm to equity holders only. Essentially, this translates to how valuable the firm is to its shareholders, as reflected in the share price.

Discounted cash flow (DCF) analysis is a complex methodology, yet it is arguably the most sound and forward-looking approach. It calculates the net present value of cash flows available to all capital providers, minus the capital needed for growth. The accuracy of this method depends heavily on the assumptions made, particularly regarding the terminal value, an important component indicating the value of cash flows into perpetuity. However, since many companies do not exist indefinitely, this can lead to inflated valuations. Therefore, I often encourage my teams to analyse discounted cash flow without attaching a terminal value initially, to assess if the shorter-term projections make sense.

The cost of capital is a key consideration in this analysis, as it reflects the opportunity cost—essentially the sacrifices investors make when they choose to invest in this company. It is crucial to exceed this cost of capital; otherwise, the projected value is diminished. Each company has its own cost of capital, determined by its capital structure, and we often use the weighted average cost of capital (WACC) to establish this.

Comparable analysis involves examining several factors, including Enterprise Value and equity value. We perform specific calculations, comparing Enterprise Value to metrics like EBITDA, sales, or cash flow. For equity value, we look at ratios such as price over earnings or price over cash flow. This allows us to categorise and compare these values to estimate the company's worth.

Additionally, we consider precedent transactions, based on the notion that this company's value may align with that of another firm whose purchase price is known. This method is beneficial because it relies on publicly available information, which is realistic and credible, and it can highlight industry trends. However, it’s important to note that public data can be limited or misleading and is subject to changing market conditions. Thus, we must evaluate whether the current valuation of this company aligns with recent transactions involving similar firms.