Valuation Methods

Valuation Overview

Valuation is the most critical skill in investment banking. Every transaction, whether an IPO, M&A deal, restructuring, or fairness opinion, requires a rigorous assessment of what a company or asset is worth. The Series 79 exam places significant emphasis on valuation methodologies, their applications, limitations, and appropriate use in different contexts.

Investment bankers typically use multiple valuation methodologies and present the results as a valuation range rather than a single point estimate. This approach recognizes that valuation is inherently uncertain and that different methodologies capture different aspects of value. The primary valuation methodologies used in investment banking are:

1. Discounted Cash Flow (DCF) Analysis: An intrinsic valuation method based on projected future cash flows
2. Comparable Company Analysis ("Trading Comps"): A relative valuation method based on public market multiples
3. Precedent Transaction Analysis ("Deal Comps"): A relative valuation method based on multiples paid in prior transactions
4. Leveraged Buyout (LBO) Analysis: A valuation framework based on a financial sponsor's ability to generate returns

The results from these methodologies are typically presented in a "football field" chart that shows the implied valuation range from each methodology, allowing stakeholders to compare and triangulate on a reasonable value range.

Discounted Cash Flow (DCF) Analysis

The DCF analysis is considered the most theoretically sound valuation methodology because it values a company based on the present value of its expected future free cash flows. The core principle is the time value of money: a dollar received today is worth more than a dollar received in the future because today's dollar can be invested to earn a return.

Step 1: Project Free Cash Flows

The first step is to project the company's unlevered free cash flows over a discrete forecast period, typically 5 to 10 years. The projection starts with revenue forecasts and builds down to unlevered free cash flow:

Unlevered Free Cash Flow = EBIT x (1 - Tax Rate) + Depreciation & Amortization - Capital Expenditures - Changes in Net Working Capital

These projections are based on detailed assumptions about revenue growth, margin trends, capital investment requirements, and working capital needs. The quality of the DCF output is entirely dependent on the quality of these assumptions.

Step 2: Calculate the Discount Rate (WACC)

Future cash flows are discounted to their present value using the Weighted Average Cost of Capital (WACC), which represents the blended cost of all capital (debt and equity) used to finance the business:

WACC = (E/V) x Re + (D/V) x Rd x (1 - T)

Where E = market value of equity, D = market value of debt, V = E + D (total enterprise value), Re = cost of equity, Rd = cost of debt, and T = corporate tax rate.

The cost of equity (Re) is most commonly estimated using the Capital Asset Pricing Model (CAPM):

Re = Rf + Beta x (Rm - Rf)

Where Rf = risk-free rate (typically the yield on 10-year U.S. Treasury bonds), Beta = the stock's sensitivity to market movements, and (Rm - Rf) = the equity risk premium (the expected return of the market above the risk-free rate).

Step 3: Calculate Terminal Value

Because it is impractical to project cash flows indefinitely, the DCF uses a terminal value to capture the value of all cash flows beyond the explicit forecast period. There are two common approaches:

• Perpetuity Growth Method (Gordon Growth Model): Assumes cash flows grow at a constant rate forever. Terminal Value = FCF(n+1) / (WACC - g), where g is the long-term growth rate, typically 2-3% (approximating long-term GDP or inflation growth).
• Exit Multiple Method: Assumes the company is sold at the end of the forecast period at a multiple of a financial metric (usually EBITDA). Terminal Value = EBITDA(n) x Exit Multiple. The exit multiple is typically derived from comparable company trading multiples.

The terminal value often represents 60-80% of the total enterprise value in a DCF analysis, making it one of the most important and sensitive assumptions. Investment bankers typically present both methods and sensitize the results.

Step 4: Discount and Sum

All projected free cash flows and the terminal value are discounted to present value using the WACC. The sum of these present values equals the implied enterprise value. To arrive at equity value, subtract net debt (total debt minus cash). To arrive at implied share price, divide equity value by diluted shares outstanding.

Comparable Company Analysis

Comparable company analysis (often called "trading comps" or simply "comps") is a relative valuation methodology that values a company by applying the valuation multiples of similar publicly traded companies. The underlying principle is that similar companies should trade at similar valuations relative to their financial metrics.

Step 1: Select Comparable Companies

The first and most critical step is selecting an appropriate peer group. Comparable companies should share similar characteristics including industry, business model, size, growth profile, profitability, geographic focus, and risk profile. The more similar the peer group, the more meaningful the analysis.

Step 2: Calculate Valuation Multiples

For each comparable company, calculate key valuation multiples including:

• EV/Revenue: Enterprise value divided by revenue. Useful for high-growth companies that may not yet be profitable.
• EV/EBITDA: Enterprise value divided by EBITDA. The most commonly used multiple in investment banking because it is capital-structure neutral and normalizes for non-cash charges.
• EV/EBIT: Enterprise value divided by EBIT. Useful when depreciation is a meaningful economic cost.
• P/E (Price/Earnings): Share price divided by earnings per share. An equity value multiple that reflects the market's assessment of the company's earnings power.
• P/B (Price/Book): Share price divided by book value per share. Primarily used for financial institutions.

Step 3: Apply Multiples to the Subject Company

Calculate the mean, median, and range of multiples from the comparable companies, then apply those multiples to the subject company's financial metrics to derive an implied valuation range.

Precedent Transaction Analysis

Precedent transaction analysis (also called "deal comps" or "transaction comps") values a company by examining the multiples paid in comparable M&A transactions. This methodology is particularly relevant when advising on M&A transactions because it reflects actual prices paid for similar companies, including any control premium (the premium a buyer pays above the target's current trading price to acquire a controlling stake).

Key Considerations

When selecting precedent transactions, investment bankers consider the target company's industry, size, growth profile, and profitability, as well as the nature of the transaction (strategic vs. financial buyer), the economic environment at the time, and how recent the transaction was. Older transactions may be less relevant if market conditions or industry dynamics have changed significantly.

Precedent transaction multiples are typically higher than comparable company trading multiples because they include the control premium, which typically ranges from 20% to 40% above the target's unaffected trading price. The control premium compensates the target's shareholders for giving up control and reflects the buyer's expectation of value creation through synergies, operational improvements, or strategic benefits.

Limitations of Precedent Transactions

• Limited universe: There may be few truly comparable transactions, particularly in niche industries
• Deal-specific factors: Each transaction reflects unique circumstances (strategic rationale, competitive dynamics, synergy expectations) that may not apply to the current situation
• Information availability: Transaction details for private deals may be limited or unavailable
• Temporal relevance: Market conditions, interest rates, and industry dynamics change over time
• Synergy differences: Different acquirers may have different synergy potential, affecting what they are willing to pay

Leveraged Buyout (LBO) Analysis

An LBO analysis is a valuation framework that determines what a financial sponsor (private equity firm) could afford to pay for a company while achieving a target rate of return, typically expressed as an internal rate of return (IRR) of 20-25%. The LBO model uses significant debt financing (leverage) to acquire the company, with the expectation of repaying that debt through the target's cash flows and ultimately realizing a return through a sale or IPO.

Key Components of an LBO Model

• Purchase Price: The total acquisition cost, including equity and debt components, plus transaction fees
• Financing Structure: The mix of debt (senior secured, subordinated, mezzanine) and equity used to fund the acquisition. Typical LBOs use 50-70% debt and 30-50% equity.
• Operating Projections: Revenue, EBITDA, and free cash flow projections for the holding period (typically 5-7 years)
• Debt Repayment Schedule: Mandatory amortization, optional prepayments, and cash sweep provisions
• Exit Assumptions: The assumed exit multiple and timing, typically a sale or IPO after 5-7 years
• Returns Analysis: Calculation of IRR and multiple of invested capital (MOIC) to the equity sponsor

Sources of LBO Returns

Private equity sponsors generate returns from three primary sources:

1. Debt Paydown: As the company's cash flows are used to repay debt, the equity component of the capital structure grows (deleveraging)
2. EBITDA Growth: Revenue growth and margin improvement increase the company's earnings, which directly increases equity value
3. Multiple Expansion: If the company can be sold at a higher multiple than the entry multiple, the difference creates additional value for equity holders

Valuation in Practice

In practice, investment bankers do not rely on any single valuation methodology. Instead, they use a multi-methodology approach and present the results in a format that allows stakeholders to understand the range of implied values and the key assumptions driving each estimate.

The Football Field Chart

The "football field" chart is the standard format for presenting valuation analysis in investment banking. It displays horizontal bars showing the implied valuation range from each methodology, allowing the reader to quickly identify areas of overlap and divergence. A typical football field chart includes ranges from the DCF analysis, comparable company analysis, precedent transaction analysis, and LBO analysis, with the current trading price (for public companies) marked as a reference point.

Premiums Paid Analysis

In M&A advisory, investment bankers also analyze the premiums paid in comparable transactions. The premium is calculated as the percentage by which the offer price exceeds the target's unaffected stock price (the price before any market speculation about a potential transaction). Premiums typically range from 20% to 50%, depending on the competitive dynamics, strategic rationale, and market conditions.

Sum-of-the-Parts Analysis

For diversified companies with multiple business segments, a sum-of-the-parts (SOTP) analysis may be more appropriate than valuing the company as a whole. SOTP involves valuing each business segment independently using the methodology and multiples most appropriate for that segment's industry, then summing the values and adjusting for corporate overhead and net debt. This approach is often used to identify a "conglomerate discount" or to support a case for a breakup or divestiture.