Valuation Basics

Revised May 12, 2014

By Scott Beber, ExcelModels

Table of Contents

1. INTRODUCTION .......................................................................................................... 3
2. METHODOLOGY 1: DISCOUNTED CASH FLOW ......................................................... 3
2.1. WEIGHTEDAVERAGECOSTOFCAPITAL ................................................................................... 3
2.2. PRESENTVALUEOFFREECASHFLOWS ..................................................................................... 3

3. METHODOLOGIES 2 AND 3: INDUSTRY MULTIPLES ................................................. 4

3.1. PRICETOEARNINGS .................................................................................................................. 4
3.2. EVTOEBITDA ......................................................................................................................... 5

4. METHODOLOGY 4: INCREMENTAL VALUE-ADD ...................................................... 5

4.1. UNDERSTANDINGSYNERGY ....................................................................................................... 5
4.2. METHODOLOGY .......................................................................................................................... 5

5. FORECASTING CASH FLOWS ..................................................................................... 6

5.1.
5.2.
5.3.
5.4.

STRAIGHTLINE .......................................................................................................................... 6
PERCENTOFSALES ..................................................................................................................... 6
COMPOUNDANNUALGROWTHRATE(CAGR) ....................................................................... 6
REGRESSION ................................................................................................................................ 6

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1. INTRODUCTION
This document is intended to explain rudimentary company valuation techniques. A rigorous valuation will often rely on
these, and other, measures, to arrive at a range.

2. METHODOLOGY 1: DISCOUNTED CASH FLOW

The Discounted Cash Flow method calculates a Net Present Value of the company as a whole. It is dependent on an
accurate depiction of historical cash flow, the basis of which is used to make cash flow projections for future years, plus
a residual value of cash flows in perpetuity thereafter. Each forecasted year is then discounted by the companys
Weighted Average Cost of Capital (WACC) to bring all future cash flows into present-day terms. The value of any
enterprise is the set of all expected future cash flows stated in todays dollars.

2.1. WeightedAverageCostofCapital
The definition of WACC can be formally stated according to the equation:

WACC = Value of Company Debt x Cost of Debt + Value of Company Equity

Value of Debt + Equity
Value of Debt + Equity

x Cost of Equity

In basic terms, a companys WACC is the opportunity cost of a dollar investment in the company versus a dollar
investment elsewhere. Cost of Equity is estimated to be historical return on equity (or Average Net Income /
Average Equity Value for as many historical years are relevant to the forecast) as a percentage of the value of
equity in the companys current capitalization. Cost of Debt is estimated to be the overall average interest rate paid
to lenders and debt financiers as a percentage of the value of debt in the companys current capitalization.
Stated differently, the WACC is the return equity that investors demand and the return that lenders demand
according to the amount each has invested in the company.

2.2. PresentValueofFreeCashFlows
The WACC figure is used as the denominator in each forecasted years cash flow value, taking into account
compounded interest for the number of years being used in the forecast (plus the residual value). Residual values
(also called valuation horizons) are often chosen arbitrarily, but tend to be a number of years for which a realistic
cash flow forecast and a realistic long-run growth rate can be made. The sum of all future years cash flow
projections, translated into present-day dollars according to the companys cost of capital, yields the companys
Present Value of Free Cash Flows (PVFCF).
The definition of PV can be formally stated according to the equation:
PV =

Cash Flow in year 1

CF year 2
...
CF year n
PV (horizon value)
2
n
n
(1+WACC)
(1+WACC)
(1+WACC)
+
+
+
1+ WACC
+

where
PV (horizon value) =

Cash Flow in year n+1

WACC - (long-run growth rate)

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3. METHODOLOGIES 2 AND 3: INDUSTRY MULTIPLES

Using the PVFCF method to value the company has advantages and disadvantages over the other major valuation
method: applying a standard industry price multiple to the companys earnings (i.e. net income).
A benefit of the PVFCF model is the theoretical accuracy. In addition to providing a company valuation, this model is
used constantly by companies to value individual projects they might undertake. The Net Present Value of a project, or
the present value less the required capital investment, must be greater than $0 for the venture to be a good use of the
companys money. Otherwise, the company is better off plowing the money back into the company and earning its
expected WACC. This is another reason why WACC represents a companys opportunity cost of capital.
The problem with the PVFCF is that theoretical accuracy requires a large number of assumptions, including:

Accurate historical and projected cash flows

Return on equity

Return on debt

WACC

Number of years to forecast

Horizon value

Long-run growth rate

If each of these figures can be estimated to a reasonable degree of accuracy, the formula for PVFCF will give a very
solid answer. NPV calculations for internal projects are generally safe to use because there is little alternative in how
worthwhile a project may be, and because by definition they give management information on a smaller scale. The value
of a company, in contrast, is arguably the most important value (the holy grail) in corporate finance and needs to be
extremely accurate in order to be useful.
In contrast, the price multiple valuation method has the advantage of being extremely safe, in the sense that a public
market has placed a value on a company or industry based on widely-available knowledge of historical and expected
performance. Given the presumption that markets are highly efficient, such a multiple is considered to be the best
available estimate of a companys value.
The problem with using a price multiple is that no two companies are alike, and using another companys basis for
valuation may or may not be appropriate to use for anothers. This holds true for using the general price multiple for an
industry as a whole. In either case, price multiples are as accurate as the similarity between a competitors or industrys
profitability, risks, and growth opportunities and the company being valued.
In fact, using an industry price multiple is often a worse method than using another companys because it is theoretically
possible to select a competitor whose business prospects more closely mimic those of ABC Corporation than using, for
example, the price multiple of the industry as a whole.
Nevertheless, it is worthwhile to use one or more price multiple valuation methods, particularly as a check against the
PVFCF results.

3.1. PricetoEarnings
A price-to-earnings ratio is simply the market price of a company divided by its earnings, or net income. The
newspaper gives the ratio of current price to the most recent earnings; however, investors are more concerned with
price relative to future earnings. Since future earnings are difficult to know for certain, projections are used, which
makes the P/E method closer to PVFCF in terms of accuracy, and helps support the argument for using PVFCF
instead. Typically, however, a P/E multiple is calculated without discounting future earnings, but rather, using past
and present earnings as indicative of the companys expected performance.

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3.2. EVtoEBITDA
EV/EBITDA ratios are similar to P/Es but rather than Price in the numerator, the Enterprise Value is used; and
EBITDA, rather than Net Income, comprises the denominator. One advantage of using EV/EBITDA over P/E is
that EBITDA is higher up on the income statement and less subject to creative accounting. By the time an earnings
estimate is derived, a lot of mitigating factors can significantly diminish the comparability between two firms.
As for the numerator, EV takes the entire company into account, rather than just the value, or Price, of its Equity.
For this reason, using a P/E ratio for an industry is a safer bet.
Nevertheless, EV/EBITDA has its drawbacks. For one, Enterprise Value requires more work to calculate than
Price. Also, there are so many ways of booking Depreciation & Amortization that EBITDA by no means immune
to creative accounting.
Particularly with growth stocks and risky ventures, Enterprise Value is still a far cry from the ultimate measure of
a companys value: cash flow. Outside of steady streams of cash, any metric can be considered a poor proxy to use
in evaluating a companys performance. Large costs, poor management, dim prospects, tough competition,
creeping regulation, obsolescence, and countless other factors can turn an otherwise attractive EBITDA-generating
company into a poor investment.

4. METHODOLOGY 4: INCREMENTAL VALUE-ADD

The most subjective of the methodologies described herein, an Incremental Value-Add analysis builds on the muchmisunderstood concept of synergy. It is a valuation of two or more individual entities being proposed as candidates for a
merger.

4.1. UnderstandingSynergy
Synergy is often correctly described as the whole is greater than the sum of the parts, but then incorrectly illustrated.
It is very difficult to find examples of true synergies in the real world. Proposed mergers often tout how joining two
companies will create synergistic effects that will lower costs or increased sales. In practice, those results almost never
hold.
What may result is a larger enterprise due to horizontal or vertical integration, or a combined entity that is better
positioned for growth. These are not synergistic, and do not produce positive Incremental Value.
For example, if two manufacturers merge their HR, Legal, or Customer Service departments under one roof and reduce
headcount, that ISNT synergy. As over 100 years of failed mergers will attest, no such merger of operations makes
things run more smoothly & efficiently in the long run. Workers might be laid off, reducing salary expense, but the net
result is ultimately a less efficient or more costly system, more work for non-downsized labor, cut corners, missed
opportunities, a worse customer experience, or some other unanticipated burden.
Someone invariably pays the supposed synergy-driven cost reduction. After the dust has cleared, the merged unit
invariably hires people back at a later date (often with decreased benefits) or increases the use of independent
contractors, to do the increased and untenable per-person workload perpetrated by the layoffs. Costs are shifted, not
eliminated. No synergy has occurred.
True synergy, on the other hand, manifests, for example, thorough implementing innovative new technology &
automation, greater leveraging of established distribution channels, or utilizing fixed-cost resources at full capacity all
resulting in greater revenue with the same costs, or lower per-unit cost of delivery for the same revenue.

4.2. Methodology
Incremental Value-Add places a new valuation on a combined company that results in greater sustainable cash flow than
that of both companies individually added together. It is a line-by-line breakdown of the Income Statements and Balance
Sheets of Company A, Company B, and Company A+B, when placed side-by-side. Typically, the comparison involves
more than just combining financial statements, and requires in-depth analysis on the quantitative effects of the resulting
merger. In the end, if the Cash Flows dont increase by more than the sum of the parts, whether due to increased
Revenues, lower Costs, or both, the Incremental Value-Add is negative. See the accompanying spreadsheet example.
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5. FORECASTING CASH FLOWS

Forecasting is most important when using the PVFCF model, because by definition an accurate estimate of future cash
flows is necessary to evaluate against the companys WACC. As mentioned in the above section, P/E and EV/EBITDA
multiples generally use past and current results in their formulas.
There are numerous methods for generating forecasts based on past and current performance, including:

5.1. StraightLine
The simplest method, Straight-Lining takes the most recent periods Cash Flow and forecasts it out at a constant
(assumed) percentage rate of growth each year; the rate is often taken to be that of the most recent years growth.

5.2. PercentofSales
The Percent of Sales method assumes an accurate medium-term Sales forecast. All Sales-driven line-items on the
income statement (e.g. COGS) and Balance Sheet (e.g. Receivables, Inventory) are grown at the same rate as
Sales. All other line-items (e.g.Salaries, Debt, Interest Expense) are fixed or treated individually). Free Cash Flow
is then calculated normally.

5.3. CompoundAnnualGrowthRate(CAGR)
CAGR takes the historical cash flows from the first and last periods and computes the singe annual percentage
growth number that, when compounded over the number of historical periods, connects the two figures. This same
growth rate is then used to project future cash flows.

5.4. Regression
A regression is a statistical analysis that attempts to explain the trend in cash flows (upward or downward) with a
trendline drawn through the data points. This line can be extrapolated out to the future to predict future cash
flows that would follow if all other factors remain constant.

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