10.2 Valuation Approaches and Methods

Valuing companies is like solving a financial puzzle. Different approaches—income, market, and asset-based—help piece together a company's worth. Each method offers unique insights, from analyzing cash flows to comparing similar businesses.

Digging deeper, we find specific tools for valuation. Market methods compare companies, while income methods forecast future cash. Asset-based approaches tally up what a company owns. These techniques give investors a well-rounded view of a company's value.

Valuation Approaches

Fundamental Valuation Approaches

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• Income approach estimates the intrinsic value of an asset based on its expected future cash flows discounted to present value
• Market approach determines the value of an asset by comparing it to similar assets that have been sold in the market
• Asset-based approach calculates the value of a company by summing the fair market value of its assets and subtracting its liabilities

Market-Based Methods

Comparable Analysis Methods

• Comparable company analysis values a company using the metrics of other businesses of similar size in the same industry and geographic region
• Precedent transactions method values a company based on the metrics of recent mergers and acquisitions of comparable companies
• Multiples valuation uses price multiples (price-to-earnings, EV/EBITDA) derived from comparable companies to determine the value of a target company
  • Price-to-earnings (P/E) ratio compares a company's current share price to its earnings per share (EPS)
  • Enterprise value to EBITDA (EV/EBITDA) compares the total value of a company, including debt and equity, to its earnings before interest, taxes, depreciation, and amortization

Income-Based Methods

Discounted Cash Flow (DCF) Valuation

• Discounted cash flow (DCF) method estimates a company's intrinsic value by projecting its future free cash flows and discounting them to present value using the weighted average cost of capital (WACC)
  • Free cash flow (FCF) is the cash generated by a company after accounting for capital expenditures and working capital needs
  • Weighted average cost of capital (WACC) is the average rate a company expects to pay to finance its assets, considering the proportion of debt and equity in its capital structure
• Terminal value represents the value of a company beyond the explicit forecast period in a DCF analysis, assuming stable growth in perpetuity
  • Gordon Growth Model is commonly used to calculate terminal value, assuming a constant growth rate for future cash flows

Option Pricing Models

• Option pricing models, such as the Black-Scholes model, are used to value assets with contingent payoffs, such as stock options and warrants
  • Black-Scholes model estimates the theoretical price of European-style options using five key determinants: current underlying price, option strike price, time until expiration, implied volatility, and risk-free interest rate

Asset-Based Methods

Liquidation Value Approach

• Liquidation value represents the estimated amount of money that would be realized if a company's assets were sold off and its liabilities were paid off
  • Orderly liquidation assumes the company has sufficient time to sell its assets at market prices
  • Forced liquidation assumes the company must sell its assets quickly, often at discounted prices
• Net asset value (NAV) is the value of a company's assets minus its liabilities, used to estimate the potential proceeds from liquidation
  • Tangible book value, a variation of NAV, only considers a company's tangible assets (property, plant, and equipment) and excludes intangible assets (goodwill, patents)