Business valuation is a key skill for investment bankers, as it helps them advise clients on mergers and acquisitions, capital raising, and restructuring. There are many methods to estimate the value of a business, but two of the most common ones are discounted cash flow (DCF) and comparables analysis. How do they differ and when should you use them?
DCF is a method that projects the future cash flows of a business and discounts them to the present value using a discount rate. The discount rate reflects the risk and opportunity cost of investing in the business. The sum of the present values of the cash flows is the DCF value of the business. DCF is based on the principle that the value of a business is equal to the present value of its future cash flows.
DCF has 3 components. 1. Free cash flows 2. Growth rate 3. Risk 1. Free cash flows: - Current earnings - Normalize them to remove anomalies - Bridge the earnings to Free cash flows (Capex, Working capital, Debt) 2. Growth: - Project the cash flows for a reasonable future - High-growth phase won’t continue, growth stagnates - Thereon, estimate what’ll be the terminal rate of growth 3. Risk: - Risk associated with realizing the above cash and growth rates - The risk is factored using discount rate. Equity risk ≠ Debt risk - So different discount rates for different instruments.
Comparables analysis is a method that compares the value of a business to the value of similar businesses in the same industry or sector. Comparables analysis uses multiples, which are ratios of a valuation metric (such as revenue, earnings, or cash flow) to a market value (such as share price or enterprise value). The most common multiples are price-to-earnings (P/E), enterprise value-to-EBITDA (EV/EBITDA), and price-to-sales (P/S). Comparables analysis is based on the principle that the value of a business is determined by the market prices of comparable businesses.
The challenge in comparable analysis is obtaining the peers. Most errors happen when the valuer doesn't understand the business model, strategy but obtains comparables which are in the broad sector. While that is not entirely wrong, it is important to understand the business to obtain peers which are as close as possible. Further, it is also important to eliminate outliers from the analysis as they will skew the data.
DCF has some advantages over comparables analysis, such as being more flexible and customizable, forward-looking, and intrinsic. However, it is also more complex and time-consuming, sensitive and uncertain, and subjective and prone to bias. DCF allows you to adjust the cash flow projections and discount rate based on your assumptions and scenarios, capturing the future growth potential and profitability of the business. Additionally, it reflects the value of the business based on its own performance and risk rather than market conditions. These benefits come with the drawbacks of requiring detailed financial modeling and forecasting, being dependent on many assumptions that can have a significant impact on the valuation, as well as being manipulable by changing assumptions to achieve a desired outcome.
In my experience, both valuation methods have their constraints and advantages. The main DCF drawback in the industry generally is the assumptions that derive the value of the equity. Sometimes following through with assumptions as well as concluding desirable outcomes of share price can be misleading and manipulative to shape the perspective of the investor themself.
Comparables analysis has some advantages over DCF, such as being simpler and quicker due to less data and calculations, more objective and reliable because it uses market-based information and observable data, and more relevant and comparable since it reflects the value of the business in relation to its peers and competitors. However, comparables analysis also has some disadvantages, such as being limited and standardized because it does not account for the unique characteristics and differences of the business, backward-looking since it relies on historical or current data that may not reflect the future prospects and performance of the business, and extrinsic as it is influenced by market fluctuations and anomalies that may not represent the true value of the business.
There is no definitive answer to which method is better or more accurate, as both have their strengths and weaknesses. The choice of the method depends on the purpose, context, and availability of the valuation. Generally, DCF is more suitable for valuing businesses that have stable and predictable cash flows, high growth potential, or significant competitive advantages; for businesses that are not comparable to other businesses in the same industry or sector; or for businesses that are undergoing significant changes or transformations. Comparables analysis is more suitable for valuing businesses that have volatile or uncertain cash flows, low growth potential, or similar competitive positions; for businesses that are comparable to other businesses in the same industry or sector; or for businesses that are relatively stable and consistent.
It is always recommended to independently value an asset using at least 2 methods. This will help understand the range of valuation and complement each other as a sense check. Two polarizing valuations in two approaches is most times an indication of some error in the valuation model.