3.5) The Purpose of Valuation Flashcards
- What’s the point of valuation? WHY do you value a company?
You value a company to determine its Implied Value according to your views.
If this Implied Value is very different from the company’s Current Value, you might be able to invest in the company and make money if its value changes.
If you are advising a client company, you might value it to tell management the price that it might receive if the company sells, which is often different from its Current Value.
- But public companies already have Market Caps and Share Prices. Why bother valuing them?
Because a company’s Market Cap and Share Price reflect its Current Value according to “the market as a whole” – but the market might be wrong!
You value companies to see if the market’s views are correct or incorrect.
- What are the advantages and disadvantages of the 3 main valuation methodologies?
Public Comps are useful because they’re based on real market data, are quick to calculate and explain, and do not depend on far-in-the-future assumptions.
However, there may not be truly comparable companies, the analysis will be less accurate for volatile or thinly traded companies, and it may undervalue companies’ long-term potential.
Precedent Transactions are useful because they’re based on the real prices that companies have paid for other companies, and they may better reflect industry trends than Public Comps.
However, the data is often spotty and misleading, there may not be truly comparable transactions, and specific deal terms and market conditions might distort the multiples.
DCF Analysis is the most “correct” methodology according to finance theory, it’s less subject to market fluctuations, and it better reflects company-specific factors and long-term trends.
However, it’s also very dependent on far-in-the-future assumptions, and there’s disagreement over the proper calculations for key figures like the Cost of Equity and WACC.
- Which of the 3 main methodologies will produce the highest Implied Values?
This is a trick question because almost any methodology could produce the highest Implied Values depending on the industry, time period, and assumptions.
Precedent Transactions often produce higher Implied Values than the Public Comps because of the control premium – the extra amount that acquirers must pay to acquire sellers.
But it’s tough to say how a DCF compares because it’s far more dependent on your assumptions.
The safest answer is: “A DCF tends to produce the most variable output since it’s so dependent on your assumptions, and Precedent Transactions tend to produce higher values than the Public Comps because of the control premium.”
- When is a DCF more useful than Public Comps or Precedent Transactions?
You should pretty much always build a DCF since it is valuation – the other methodologies are supplemental.
But it’s especially useful when the company you’re valuing is mature and has stable, predictable cash flows or when you lack good Public Comps and Precedent Transactions.
- When are Public Comps or Precedent Transactions more useful than the DCF?
If the company you’re valuing is early-stage and you cannot estimate its future cash flows, or if the company has no path to positive cash flows, you must rely on the other methodologies.
These other methodologies can also be more useful when you run into problems in the DCF, such as the inability to estimate the Discount Rate.
- Which one should be worth more: a $500 million EBITDA healthcare company or a $500 million EBITDA industrials company?
Assume the growth rates and margins are the same.
In all likelihood, the healthcare company will be worth more because healthcare is a less asset-intensive industry. That means the company’s CapEx and Working Capital requirements will be lower, and its Free Cash Flow will be higher (i.e., closer to EBITDA).
Healthcare, at least in some sectors, also tends to be more of a “growth industry” than industrials.
The Discount Rate might also be higher for the healthcare company, but the lower asset intensity and higher expected growth rates would likely make up for that.
However, this answer is an extreme generalization, so you need more information to give a detailed answer.
- How do you value an apple tree?
The same way you value a company: comparable apple trees and a DCF. You’d look at what similar apple trees have sold for and calculate the expected future cash flows from this tree.
You would then discount these cash flows to Present Value, discount the Terminal Value to PV, and add everything to determine the apple tree’s Implied Value.
The Discount Rate would be based on your opportunity cost – what you might be able to earn each year by investing in other, similar apple trees.
- People say that the DCF is intrinsic valuation, while Public Comps and Precedent Transactions are relative valuation. Is that correct?
No, not exactly. The DCF is based on the company’s expected future cash flows, so in that sense, it is “intrinsic valuation.”
But the Discount Rate used in the DCF is usually linked to peer companies (market data), and if you use the Multiples Method to calculate Terminal Value, the multiples are also linked to peer companies.
The DCF depends less on the market than the other methodologies, but there is still some dependency.
It’s more accurate to say that the DCF depends more on your views of the company’s long-term prospects and less on market data than the other methodologies.
