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How to evaluate a company: evaluation methods


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If you want to learn how to value a company using different valuation methods, you are in the right place. Estimating the equity value of a stock is not an easy task, and one of the main difficulties for many analysts is choosing the right valuation method.

It is very important to master several valuation models to find the intrinsic value of a business. Being biased towards one particular methodology can negatively impact investment decisions and lead to capital losses and missed opportunities! This article will review the most popular valuation methods for determining the fair value of a company.

1# Valuation method: DCF analysis

Discounted cash flow (DCF) valuation is one of the most popular methods used by equity analysts to estimate the fair value of a company based on projections of how much cash flow it will generate in the future.

So the first step is to create a DCF valuation model forecasting future free cash flows. Because estimating FCF directly can be difficult, it is common practice to first forecast revenue and derive FCF by making the necessary adjustments.

Because we can’t forecast cash flows continuously, most analysts forecast them five or ten years out and then estimate the final valuewhich represents the value of the business at the end of the forecast period.

After we have predicted the company’s future free cash flows and its terminal value, we must find their present value by discounting them to the present using our required rate of return. Earned value is the amount an investor must pay for the business to achieve the desired rate of return.

Any price below the DCF value will result in a higher rate of return. On the other hand, if an investor pays more than the cost of a DCF, they should expect a lower rate of return. Below is an example of the results of Apple’s DCF analysis. According to the model, Apple’s fair value is $84.51, which is -29% below the current price of $119.03.

Source: DCF Finbox Analysis Summary (You can access the full model for free here)

2# Evaluation method: comparative analysis

Comparable company analysis, also known as “comps,” is a widely used valuation technique that estimates the fair value of a business by comparing its valuation metrics to similar companies selected based on their industry, size, growth, and various financial metrics.

The benchmarking method works on the assumption that similar companies should trade at similar valuation multiples. Below is an example of Apple’s benchmarking using different EBITDA multipliers. According to the model, Apple’s fair value is $82.44, which is -31% below the current price of $119.03.

an example of a comparative company analysis model

Source: Summary of the Finbox peer review model (You can access the full model for free here)

3# Valuation method: Dividend discount model

Among the various valuation methods used to value businesses, the dividend discount model is another reliable method used to predict the value of dividend paying companies. The dividend discount model is based on the assumption that the fair value of a stock is equal to the sum of its future dividends discounted to the present.

Below is an example summary of Apple’s dividend discount model (constant growth). According to the model, Apple’s fair value is $85.34, which is -28% below the current price of $119.03.

example of dividend discount model estimation

Source: Summary of the Finbox DDM model (You can access the full model here)

4# Valuation method: precedent transaction

The precedent-setting transaction valuation method attempts to estimate the fair value of a business by analyzing the price paid to acquire similar companies in the past M&A transactions. In this way, the analyst can estimate how much a share of the company’s stock will be worth at the time of acquisition.

Benchmark transaction valuation is very similar to comparable company analysis – in both approaches, the fair value of a company is estimated by comparing its multiple assessments other enterprises. While both involve a relative approach to valuation, the main difference is that in peer analysis the analyst takes into account current valuation ratios, while in previous transactions the analyst must also consider the takeover premium.

For obvious reasons, one of the most important factors in using this valuation method is the identification of relevant precedent transactions, which in some industries do not occur very often. In addition, another difficulty is finding accurate information about previous M&A deals and creating a reliable estimate of premiums and multiples.

One of the most effective ways to summarize the various estimates obtained from all assessment methods is to develop a ballpark diagram. It’s called a football field chart because the bars used in the chart resemble the yard lines on a football field and because bankers like to draw sports analogies.

The main purpose of using this method is to generalize and test the reasonableness of different methodologies and see how they compare to each other. The purpose of a ballpark chart is to show how much a potential buyer is willing to pay for a particular business, whether they are buying a single stock, part of a stock, or all of a stock.

Below is an example of Apple’s ballpark chart showing the different fair value estimates we obtained using different valuation methods. According to the models, Apple’s average fair value is $87.14, which is -27% below the current price of $119.03.

assessment methods - football field diagram

Source: Finbox Apple Football Field Diagram (You can access it for free here)

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