In the world of mergers and acquisitions, business valuation is one of, if not the most important aspect to completing a deal. Essentially, business valuation is the process of determining an adequate value to purchase a business at. There are three primary ways to perform valuations which will be introduced in this article.
- Discounted Cash Flow (DCF) Analysis
As implied by its name, a discounted cash flow (DCF) analysis uses current and future projections of the amount of money flowing in and out of a business to assign a price to it. The essence of this valuation technique is the belief that the more cash a business can generate, the more valuable it is. Furthermore, it uses the idea that money in the present is worth more than money in the future due to factors such as potential investments as well as inflation. The proportional reduction in the value of the cash flow each succeeding year is known as the discount rate. The aggregated total of these cash flows during the investment period is known as the net present value, or the final valuation given to the business.
DCF Formula: CF1(Cash Flow Year 1)/(1+DR(discount rate))^1 + … + CFN(Cash Flow Year N)/(1+DR(discount rate))^N
The primary advantage of the DCF analysis is consistency: since it relies on cash flows to determine value, it is not affected by short-term market fluctuations.
- Comparable Companies Analysis
Another valuation technique is the comparable companies analysis. This technique values a company based on its financial position relative to other companies that are similar to it and uses the valuation of those companies as a point of reference. It utilizes several valuation ratios such as price to earnings (P/E), price to book (P/B), etc. As a simplified example of how this may work, let’s say Company A is a construction business that has an annual EBITDA of $5 million. On the stock market, the construction industry is trading at an average of 10 times EBITDA. Thus, the valuation for Company A would be $50 million. The advantage of this technique is that it is fairly straightforward and intuitive, while the primary disadvantage is that it could be vulnerable to short-term market volatility.
- Precedent Transactions Analysis
The precedent transactions analysis is similar to the comparable companies analysis, but instead of using presently traded companies it uses similar companies that have already been acquired through M&A transactions as the benchmark for valuation. The advantage of this technique is that it more accurately portrays what a company is likely to be valued at in a M&A deal. The disadvantage is that valuation multiples used in past transactions may be less relevant than the present multiples that can be accessed through the comparable companies analysis.
- Mirzayev, E. (2020, April 24). Discounted Cash Flows vs. Comparables. Retrieved July 02, 2020, from https://www.investopedia.com/articles/professionals/072915/dcf-vs-comparables-which-one-use.asp
- Tuovila, A. (2020, June 29). Cash Flow. Retrieved July 02, 2020, from https://www.investopedia.com/terms/c/cashflow.asp
- Chen, J. (2020, May 13). Discounted Cash Flow (DCF). Retrieved June 29, 2020, from https://www.investopedia.com/terms/d/dcf.asp
- Kenton, W. (2020, May 31). Precedent Transaction Analysis Definition. Retrieved July 02, 2020, from https://www.investopedia.com/terms/p/precedent-transaction-analysis.asp
- Chen, J. (2020, March 19). Comparable Company Analysis (CCA) Definition. Retrieved June 29, 2020, from https://www.investopedia.com/terms/c/comparable-company-analysis-cca.asp