First Chicago Method: A Practical Approach to Valuing Companies"

Understanding the First Chicago Method

The First Chicago Method, in simple terms, is a method to determine the value of a company based on different possible scenarios. It recognizes that predicting the future of fast-growing companies can be tricky due to their wide range of potential outcomes.

Embracing Scenario Planning

Imagine you're predicting the weather - you consider three scenarios: sunny, cloudy, and rainy. Similarly, the First Chicago Method assesses three scenarios for a company's value:

Base Case: This is the most likely outcome, where everything goes as planned.

Upside Case: The best-case scenario, where things go even better than expected.

Downside Case: The worst-case scenario, where things don't go as planned.

The Valuation Ingredients

To bake this valuation cake, we need two key ingredients: Discounted Cash Flow (DCF) and the Venture Capital Method. These ingredients help in estimating the company's worth under different scenarios. The assumptions you make, like growth rates and discount rates, influence the final valuation.

The Balance Between Scenarios

Ever heard of "hope for the best, prepare for the worst"? The First Chicago Method follows a similar philosophy. While the base case is the most probable, the method acknowledges that the worst-case scenario, though less likely, is still essential to consider.

Walking the Steps

Imagine preparing a recipe. In this case, the recipe involves listing the scenarios in a table. Alongside each scenario, you add two columns: one for the likelihood of that scenario happening and the other for the valuation amount corresponding to that scenario.

The Result: Implied Valuation

After the table is set, you multiply each scenario's probability with its valuation, then sum these up. This sum is the implied valuation.

The Pros and Cons

Like any method, the First Chicago Method has its strengths and weaknesses. It's great because it factors in various outcomes, offering a flexible approach. However, it can be time-consuming and relies on subjective assumptions.

Putting Theory into Practice

Let's bring this down to earth with an example. Say we're valuing a growing company. Under different scenarios, the valuations could be $100 million for the base case, $150 million for the upside case, and $50 million for the downside case. Assigning probabilities of 50%, 25%, and 25% respectively, the weighted valuation lands around $100 million.

Conclusion

The First Chicago Method may sound complex, but it's essentially like weighing probabilities in everyday decision-making. By assigning weights to different outcomes, this method creates a comprehensive picture of a company's potential value. It's a tool that embraces uncertainty and offers a sensible approach to valuing companies with unpredictable futures.