If you are interested in private equity, you need to know how to value a company. Two common methods are discounted cash flow (DCF) analysis and comparable company analysis. But what are the differences between them and when should you use each one? In this article, you will learn the basics of both techniques and how they can help you make better investment decisions.
DCF analysis is a method of valuing a company based on its future cash flows. You estimate how much cash the company will generate over a certain period, usually five to ten years, and discount it back to the present using a discount rate. The discount rate reflects the risk and opportunity cost of investing in the company. The sum of the discounted cash flows is the enterprise value of the company, which you can then adjust for debt, cash, and other items to get the equity value. DCF analysis is based on your own assumptions and projections, so it can capture the unique characteristics and growth potential of the company.
Comparable company analysis is a method of valuing a company based on the market prices of similar companies. You identify a set of comparable companies that operate in the same industry, have similar size, growth, profitability, and risk profiles, and trade on the same market. You then calculate various valuation multiples for each comparable company, such as price-to-earnings, enterprise value-to-EBITDA, or price-to-book. You apply the average or median multiple to the target company's financial metrics to get its implied value. Comparable company analysis is based on market data, so it reflects the current sentiment and expectations of investors.
1- Foundation: DCF: Values based on future cash flows. CCA: Uses valuation multiples of similar firms. 2- Data: DCF: Needs company-specific future projections. CCA: Uses public data of comparable firms. 3- Viewpoint: DCF: Forward-looking. CCA: Relative valuation. 4- Sensitivity: DCF: Sensitive to growth and discount assumptions. CCA: Influenced by choice of comparables. 5- Use-case: DCF: Best for firms with predictable flows. CCA: Ideal when similar sector firms abound.
One of the main advantages of DCF analysis is that it is forward-looking and intrinsic. It does not rely on market prices, which can be volatile, irrational, or influenced by external factors. It also allows you to incorporate your own views and scenarios into the valuation, such as different growth rates, margins, capital expenditures, or exit multiples. DCF analysis can be useful for valuing companies that have high growth potential, stable cash flows, or unique competitive advantages that are not reflected in the market.
One of the main advantages of comparable company analysis is that it is simple and relative. It does not require complex modeling, forecasting, or discounting. It also provides a benchmark for how the market values similar companies, which can be helpful for assessing the reasonableness of your valuation or negotiating a deal price. Comparable company analysis can be useful for valuing companies that have low growth potential, uncertain cash flows, or no clear competitive advantages that differentiate them from their peers.
One of the main limitations of DCF analysis is that it is highly sensitive to your assumptions and inputs. A small change in the discount rate, growth rate, or terminal value can have a significant impact on the valuation. It can also be difficult to estimate the future cash flows of a company, especially if it is in a fast-changing or uncertain industry. DCF analysis can be misleading or inaccurate if your assumptions are unrealistic, biased, or inconsistent.
One of the main limitations of comparable company analysis is that it is based on the assumption that the comparable companies are truly comparable. In reality, it can be hard to find a perfect match for the target company, as every company has its own strengths, weaknesses, opportunities, and threats. It can also be challenging to select the appropriate valuation multiple, as different multiples can imply different growth, risk, and profitability assumptions. Comparable company analysis can be flawed or incomplete if your comparables are not representative, relevant, or updated.