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What are the most effective valuation methods for PE due diligence?

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When you are evaluating a potential target for a private equity (PE) deal, you need to assess its value and risk profile. This is not an easy task, as different valuation methods may yield different results and imply different assumptions. In this article, we will explore some of the most effective valuation methods for PE due diligence, and how to use them in different scenarios.

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1 Market multiples

One of the simplest and most common valuation methods for PE due diligence is to compare the target with similar companies that have been recently traded or acquired in the market. This method involves calculating multiples, such as enterprise value (EV) to earnings before interest, taxes, depreciation, and amortization (EBITDA), or price to earnings (P/E), and applying them to the target's financial metrics. The advantage of this method is that it reflects the current market conditions and expectations, and it is easy to apply and communicate. The disadvantage is that it may not capture the unique characteristics and growth prospects of the target, and it may be influenced by outliers and market fluctuations.

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Zhong Li, CFA?

Financial Advisor at Edward Jones
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It's basically the most favorable to the companies when the market is hot, and PE would counter by the discounted model or historic model. but in general, PE won't have a long time span investing, so the 3-5 years horizon will be choosing some similar market multiple to estimate a close target. some big hot chick will get some premium, after all it's the buy-sell equibrium in the primary market

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2 Discounted cash flow

Another popular valuation method for PE due diligence is to discount the future cash flows of the target to their present value, using an appropriate discount rate. This method involves projecting the target's free cash flow (FCF), which is the cash available to the owners after paying for operating expenses and investments, and discounting it by the weighted average cost of capital (WACC), which is the average cost of financing the target's assets. The advantage of this method is that it reflects the intrinsic value of the target based on its expected performance and cash generation, and it allows for different scenarios and sensitivities. The disadvantage is that it relies on many assumptions and estimates, such as the growth rate, the terminal value, and the WACC, which may be difficult to obtain or validate.

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Zhong Li, CFA?

Financial Advisor at Edward Jones
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it's the most manipulated method, the only logical method, and the most misunderstood method. because of the assumption can cause huge difference , like end value, discount rate etc. it is supplementary in pricing.

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3 Leveraged buyout

A more specific valuation method for PE due diligence is to simulate the leveraged buyout (LBO) of the target, and calculate the internal rate of return (IRR) that the PE firm would achieve from the deal. This method involves estimating the amount and structure of debt and equity that the PE firm would use to finance the acquisition, and projecting the cash flows and exit value of the target under the PE firm's ownership and management. The advantage of this method is that it reflects the PE firm's perspective and objectives, and it incorporates the effects of leverage and value creation. The disadvantage is that it requires a lot of inputs and assumptions, such as the purchase price, the debt terms, the exit multiple, and the operational improvements, which may vary significantly across different PE firms and deals.

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Zhong Li, CFA?

Financial Advisor at Edward Jones
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will lock in the cost of money in LBO, the risk buffer of different types ,and the path to safety in these leverage project. basically similar in valuation of the business part, the difference is the cost of borrowing.

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4 Other methods

There are other valuation methods that may be useful for PE due diligence, depending on the context and purpose of the analysis. For example, you may use the replacement cost method, which estimates the value of the target based on the cost of replacing its assets, to assess the downside risk or the liquidation value of the target. Or, you may use the real options method, which values the target based on the flexibility and opportunities that it offers, to capture the upside potential or the strategic value of the target. The choice of the valuation method depends on the availability and quality of data, the comparability and relevance of peers, the stage and type of the deal, and the preferences and expectations of the PE firm and the target.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Zhong Li, CFA?

Financial Advisor at Edward Jones
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some premium based on the growth and market competition position will be given. there will be other things to discussed , unique project will be set premium, like open AI, pingduoduo etc.

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What are the most effective valuation methods for PE due diligence?

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1 Market multiples

2 Discounted cash flow

3 Leveraged buyout

4 Other methods

5 Here’s what else to consider

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