As an analyst, knowing the main methods of how to value corporations is by far the most important set of skills you can gain as a junior. Here we discuss the three main methods you need to know about in order to value a company. If you're thinking about Investment Banking as a career, read on.
1. Comparable Companies Analysis (CCA)
The foundation of this exercise is built upon the principle that similar companies can provide a point of reference to value an external one. For example, when trying to value a new technology start up, you are more likely to compare it with a related start up rather then a food delivery company.
Keeping this in mind, a CCA exercise will start with an analyst gathering a host of similar companies that share key financial statistics and indicators. This information is then listed on an excel sheet- the lifeline of any analyst- and benchmarked against a target company.The analyst will calculate financial ratios, referred to in the investment-banking world as “trading multiples”, which act as a base to come up with a valuation range for the target company. An example of these trading multiples is EV/EBITDA, which is one of the most heavily used multiples in company valuation. This is a measure of the cost of a stock.
Finally, the analyst will estimate a range for the given company by manipulating the target’s financial history and the relevant trading multiple.
2. Precedent Transaction Analysis
This approach also uses a multiples based method like the one seen in comparable companies analysis. The exercise mainly revolves around looking at multiples and sums paid for similar companies in the past. It’s mainly used in M&A transactions, where clients are looking to purchase or merge with a given company.
The analyst will look closely at the multiples paid in these transactions of a particular industry, giving him/her guidelines to extrapolate a valuation range for the sale/purchase of a firm for the client. As a result, analysts will typically be aware of the trading multiples used in their covered industries.
3. Discounted Cash Flow (DCF) Analysis
This is one of the most vital concepts to grasp as an analyst since DCF analysis has fundamental use in almost every investment banking transaction.
This appraisal can become very technical, very quickly, and will need some patience on the analyst’s part. At the core of it, is projecting the present value of a company’s free cash flow and “terminal value” to realise it’s “intrinsic” worth. To find the present value of these, an important concept must be understood: that the discount rate is set on a company’s WACC (Weighted Average Cost of Capital).
This can be recognized as the opportunity cost of capital or the rate of return on alternative investments with similar risk. One of the most confusing aspects of this investigation is grasping a company’s terminal value. To get your head around this, you should take stock that it is naturally difficult to estimate accurate cash flows over an extended period of time, and thus a theoretical figure will be necessary to capture the remaining worth of a company.
All of this may seem confusing at first but reading through this overview a few times will help make this process second nature to you. For more information please visit: My_CorpFinance - a twitter account dedicated to assisting students in learning valuation methodology and what’s needed to break into the investment banking industry.