The three most commonly used methods for valuing a company are the discounted cash flow method (DCF), the comparable multiples method and the comparable transactions method. As a short reminder, the DCF is the present value of the forecasted free cash flows of the company discounted at an appropriate rate representing the risk of these cash flows (the weighted average cost of capital); the comparable multiples method consists of valuing a company by considering various valuation multiples (ratios) of comparable currently trading companies (examples of multiples include Price/Earnings, Enterprise Value/EBITDA �); finally the comparable transactions method consists of valuing a company by considering the valuations implied by recent transactions of comparables companies.
In theory, the DCF should give the most accurate value since it represents the intrinsic value of the company based only on its forecasted free cash flows but as all methodology which is based on forecasts, there is a strong bias especially on the expected growth, a fact specifically true when considering that these numbers are more often given by the management whose optimism is never far away.
However, a company is not on its own; it�s part of a market which encourages relative valuation between comparable companies. Different elements can come into account to explain the differences in valuation between comparable companies; they can be related to the financial structure (leverage), profitability, market position, exposure to different markets (particularly emerging markets). The problematic with this method is that does not enable to give an absolute value since it will be continuously influenced by the valuation by the market of the particular sector. It can be of best use when considering an IPO by giving a valuation range based on the current prices of comparables companies by the market.
The two previous methods enable us to approximate a value for the company standalone (as an investment or part of) but there is still a control premium that must me paid by an acquirer that will be sufficient for the previous owners to tender their shares to an eventual offer. This premium is calculated by reviewing recent transactions of comparable companies. In most cases, the value range indicated by the comparable transactions will be higher than that of comparable multiples due to the control premium. However, there are rare situations where this could not be the case like following the dotcom bubble, the comparable multiples were low for technological companies, but with the fittest surviving and results (profits) being realized, comparable multiples regained while premiums did not follow the same trend due to the reluctance of companies (and their shareholders) to acquire technological companies which had still to confirm their profitable status. The comparable transactions method is of best use in the case of a change of control as occurring in mergers & acquisitions.
30/09/2005 Marc-Albert Hamalian
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