What is Valuation?
Valuation refers to the process of determining the current or projected worth of a company. There are several ways to value a company, and these various methods can be categorized into two groups: 1. Intrinsic Valuation and 2. Relative Valuation. Intrinsic Valuation attempts to find the "inherent" or "true" value of an investment based solely on the company's fundamentals, including its cash flows, growth rates, dividends, etc. It does not take into account how other companies are performing. The most common Intrinsic Valuation method is the Discounted Cash Flow Analysis (often referred to as 'DCF Analysis'). The DCF Analysis method estimates the value of a company today based on its expected future cash flows (i.e., how much money it will generate in the future). This method is often considered to be the most rigorous and theoretically correct way of valuing a company, but it is worth noting that the DCF Analysis also relies heavily on assumptions due to its forward-looking nature. The Discounted Cash Flow Analysis page linked below will cover this valuation methodology in more detail.
Relative Valuation, on the other hand, operates by comparing the company being valued to other similar companies. This methodology involves calculating various valuation ratios and multiples of "comparable" peer companies or M&A transactions, including the Price-to-Earnings ratio and the Enterprise Value-to-EBITDA multiple (more on what 'Enterprise Value' means below), and then applying those ratios and multiples to the company you are valuing. The two most common Relative Valuation methodologies are Comparable Companies Analysis (often referred to as 'Comps Analysis') and Precedent Transactions Analysis in which one calculates the ratios of various comparable public companies and various announced transactions respectively. For example, in the case of a Comps Analysis, say you are trying to value a company with an EBITDA of $50 million. If similar companies (in the same sector with similar risk and growth profiles) are trading at Enterprise Value-to-EBITDA multiples of between 15x and 20x, then the technology company you are valuing should, in theory, have an Enterprise Value of between $750 million ($50 million * 15) and $1 billion ($50 million * 20). Generally speaking, Relative Valuation is a lot easier and quicker to conduct than Intrinsic Valuation. Relative Valuation also relies on current market data rather than on cash flow projections and is thus the best representation of market value. That being said, the market can be incorrect (especially in the long-run) and it is often difficult to come up with a good set of comparable companies or transactions. The Comparable Companies Analysis and Precedent Transactions Analysis pages linked below will cover the two Relative Valuation methodologies in more detail.
Equity & Enterprise Value
Equity Value and Enterprise Value are two common ways that a company may be valued. Both are used in the valuation of a business but each offers a slightly different perspective.
Equity Value is often referred to as the "Market Capitalization" of a company. It is the value of everything a company has (Total Assets - Total Liabilities) but only to equity investors, i.e., common stock holders. Enterprise Value is the value of a company's core business operations (Operating Assets - Operating Liabilities) but to all investor groups, including, equity, debt, preferred stock holders, etc.
How Do You Value a Company?
As mentioned previously, there are several ways to value a company. The three most common valuation methodologies are:
Test your valuation understanding: