Valuation Methods
The main methods used to value a business
Written by CFI Team
Updated May 7, 2022
What are the Main Valuation Methods?
When valuing a company as a going concern, there are three main valuation
methods used by industry practitioners: (1) DCF analysis, (2) comparable
company analysis, and (3) precedent transactions. These are the most
common methods of valuation used in investment banking, equity research,
private equity, corporate development, mergers & acquisitions (M&A),
leveraged buyouts (LBO), and most areas of finance.
Image: CFI’s Business Valuation Course.
As shown in the diagram above, when valuing a business or asset, there are
three different methods or approaches one can use. The Cost Approach looks
at what it costs to rebuild or replace an asset. The cost approach method is
useful in valuing real estate, such as commercial property, new construction, or
special use properties. Finance professionals do not typically use it to value a
company that is a going concern.
Next is the Market Approach, which is a form of relative valuation and is
frequently used in the industry. It includes Comparable Analysis and Precedent
Transactions.
Finally, the discounted cash flow (DCF) approach is a form of intrinsic
valuation and is the most detailed and thorough approach to valuation
modeling. We will describe the methods used in the Market and DCF
approaches below.
Method 1: Comparable Analysis (“Comps”)
Comparable company analysis (also called “trading multiples” or “peer group
analysis” or “equity comps” or “public market multiples”) is a relative valuation
method in which you compare the current value of a business to other similar
businesses by looking at trading multiples like P/E, EV/EBITDA, or other
ratios. Multiples of EBITDA are the most common valuation method.
The “comps” valuation method provides an observable value for the business,
based on what other comparable companies are currently worth. Comps are
the most widely used approach, as they are easy to calculate and always
current. The logic follows that if company X trades at a 10-times P/E ratio, and
company Y has earnings of $2.50 per share, company Y’s stock must be worth
$25.00 per share (assuming the companies have similar attributes).
Example Comps Table
Method 2: Precedent Transactions
Precedent transactions analysis is another form of relative valuation where you
compare the company in question to other businesses that have recently been
sold or acquired in the same industry. These transaction values include the
take-over premium included in the price for which they were acquired.
The values represent the en bloc value of a business. They are useful for M&A
transactions but can easily become stale-dated and no longer reflective of the
current market as time passes. They are less commonly used than Comps or
market trading multiples.
Example Transaction Analysis
Method 3: DCF Analysis
Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an
analyst forecasts the business’ unlevered free cash flow into the future and
discounts it back to today at the firm’s Weighted Average Cost of Capital
(WACC).
A DCF analysis is performed by building a financial model in Excel and requires
an extensive amount of detail and analysis. It is the most detailed of the three
approaches and requires the most estimates and assumptions. However, the
effort required for preparing a DCF model will also often result in the most
accurate valuation. A DCF model allows the analyst to forecast value based on
different scenarios and even perform a sensitivity analysis.
For larger businesses, the DCF value is commonly a sum-of-the-parts analysis,
where different business units are modeled individually and added together.
To learn more, see CFI’s DCF model infographic.
DCF Valuation Model
Image: CFI’s Business Valuation Course.
Football Field Chart (summary)
Investment bankers will often put together a football field chart to summarize
the range of values for a business based on the different valuation methods
used. Below is an example of a football field graph, which is typically included
in an investment banking pitch book.
As you can see, the graph summarizes the company’s 52-week trading range
(it’s stock price, assuming it’s public), the range of prices analysts have for the
stock, the range of values from comparable valuation modeling, the range
from precedent transaction analysis, and finally the DCF valuation method. The
orange dotted line in the middle represents the average valuation from all the
methods.
Image: Free Football Field Chart.
More Valuation Methods (Video)
The cost approach, which is not as commonly used in corporate finance,
looks at what it actually costs or would cost to rebuild the business. This
approach ignores any value creation or cash flow generation and only looks at
things through the lens of “cost = value.”
Another valuation method for a company that is a going concern is called
the ability to pay analysis. This approach looks at the maximum price an
acquirer can pay for a business while still hitting some target. For example, if
a private equity firm needs to hit a hurdle rate of 30%, what is the maximum
price it can pay for the business?
If the company does not continue to operate, then a liquidation value will be
estimated based on breaking up and selling the company’s assets. This value is
usually very discounted as it assumes the assets will be sold as quickly as
possible to any buyer.
