How to Know Which Valuation Technique to Use
Originally published: 13/12/2017 14:54
Publication number: ELQ-10259-1
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How to Know Which Valuation Technique to Use

This guide shows the pros and cons of valuation methods and when to use each valuation technique

Introduction

Investment banks perform two basic, critical functions for the global marketplace. First, investment banks act as intermediaries between those entities that demand capital (e.g. corporations) and those that supply it (e.g. investors). This is mainly facilitated through debt and equity offerings by companies. Second, investment banks advise corporations on mergers & acquisitions (M&A), restructurings, and other major corporate actions. The majority of investment banks perform these two functions, although there are boutique investment banks that specialize in only one of the two areas (usually advisory services for corporate actions like M&A).


In providing these services, an investment bank must determine the value of a company. How does an investment bank determine what a company is worth? In this guide you will find a detailed overview of the valuation techniques used by investment bankers to facilitate these services that they provide.


In this chapter we will cover two primary topic areas:


> How do bankers determine how much a company is worth—in other words, what valuation techniques are typically used?
> What are the advantages and disadvantages of each valuation technique, and when should which technique be used?

  • Step n°1 |

    Valuation Techniques: Overview

    While there are many different possible techniques to arrive at the value of a company—a lot of which are company, industry, or situation-specific—there is a relatively small subset of generally accepted valuation techniques that come into play quite frequently, in many different scenarios. We will describe these methods in greater detail later in this training course:


    >Comparable Company Analysis (Public Comps): Evaluating other, similar companies’ current valuation metrics, determined by market prices, and applying them to the company being valued.
    >Discounted Cash Flow Analysis (DCF): Valuing a company by projecting its future cash flows and then using the Net Present Value (NPV) method to value the firm.
    >Precedent Transaction Analysis (M&A Comps): Looking at historical prices for completed M&A transactions involving similar companies to get a range of valuation multiples. This analysis attempts to arrive at a “control premium” paid by an acquirer to have control of the business.
    >Leverage Buyout/“Ability to Pay” Analysis (LBO): Valuing a company by assuming the acquisition of the company via a leveraged buyout, which uses a significant amount of borrowed funds to fund the purchase, and assuming a required rate of return for the purchasing entity.


    These valuation techniques are easily the most commonly used, other than in valuations for specific, niche industries such as oil & gas or metal mining (and even in those industries, the aforementioned valuation techniques frequently come into play). Different parts of the investment bank will use these core techniques for different needs in different circumstances. Frequently, however, more than one technique will be used in a given situation to provide different valuation estimates, with the concept being to triangulate a company’s value by looking at it from multiple angels.


    For example, M&A bankers are typically most interested in Transaction and Comparables valuation for acquisition and divestiture. Equity Capital Markets (ECM) bankers underwrite company shares in the public equity markets in advance of an initial public offering (IPO) or secondary offering, and thus rely heavily on Comparables valuation. Financial sponsors and leveraged finance groups will almost always value a company based upon leveraged buyout (LBO) transaction assumptions, but will also look at others. Also, in many cases, all of these groups will employ some degree of DCF valuation analysis. These different divisions of an investment bank may come up with similar valuation ranges using some subset of the techniques given, but will approach this process often with entirely different goals in mind.


    Thus all of these techniques are used routinely by investment banks, and for a banking analyst, at least some degree of familiarity with all of these techniques must be achieved in order for that analyst to be considered proficient at his or her job.

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