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Valuation methods
An overview

2001 M. P.
Narayanan

University of Michigan

Methodologies

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Comparable multiples
P/E multiple
Market to Book multiple
Price to Revenue multiple
Enterprise value to EBIT multiple
Discounted Cash Flow (DCF)
NPV, IRR, or EVA based Methods

WACC method
APV method
CF to Equity method

2001 M. P.

University of

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Valuation: P/E multiple

If valuation is being done for an IPO or a takeover,

Value of firm = Average Transaction P/E multiple EPS of
firm
Average Transaction multiple is the average multiple of recent
transactions (IPO or takeover as the case may be)
If valuation is being done to estimate firm value
Value of firm = Average P/E multiple in industry EPS of firm
This method can be used when
firms in the industry are profitable (have positive earnings)
firms in the industry have similar growth (more likely for
mature industries)
firms in the industry have similar capital structure

2001 M. P.

University of

Valuation: Price to book multiple

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The application of this method is similar to that of the

P/E multiple method.

Since the book value of equity is essentially the
amount of equity capital invested in the firm, this
method measures the market value of each dollar of
equity invested.
This method can be used for

companies in the manufacturing sector which have significant

capital requirements.
companies which are not in technical default (negative book
value of equity)

2001 M. P.

University of

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Valuation: Value to EBITDA

multiple

This multiple measures the enterprise value, that is

the value of the business operations (as opposed to

the value of the equity).
In calculating enterprise value, only the operational
value of the business is included.
Value from investment activities, such as investment in
treasury bills or bonds, or investment in stocks of other
companies, is excluded.
The following economic value balance sheet clarifies
the notion of enterprise value.

2001 M. P.

University of

Enterprise Value

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Economic Value Balance Sheet

PV of future cash from business
operations

$1500

Cash

$200

Debt

Marketable securities

$150

Equity

$1850

$650
$1200
$1850

Enterprise Value

2001 M. P.

University of

Value to EBITDA multiple:

Example

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Suppose you wish to value a target company using the

following data:

Enterprise Value to EBITDA (business operations only)

multiple of 5 recent transactions in this industry: 10.1, 9.8, 9.2,
10.5, 10.3.
Recent EBITDA of target company = $20 million
Cash in hand of target company = $5 million
Marketable securities held by target company = $45 million
Interest rate received on marketable securities = 6%.
Sum of long-term and short-term debt held by target = $75
million

2001 M. P.

University of

FIN

Value to EBITDA multiple:

Example

Average (Value/ EBITDA) of recent transactions

(10.1+9.8+9.2+10.5+10.3)/5 = 9.98
Interest income from marketable securities
0.06 45 = $2.7 million
EBITDA Interest income from marketable securities
20 2.7 = $17.3 million
Estimated enterprise value of the target
9.98 17.3 = $172.65 million
Add cash plus marketable securities
172.65 + 5 + 45 = $222.65 million
Subtract debt to find equity value: 222.65 75 = $147.65
million.

2001 M. P.

University of

Valuation: Value to EBITDA

multiple

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Since this method measures enterprise value it

accounts for different

capital structures
cash and security holdings

By evaluating cash flows prior to discretionary capital

investments, this method provides a better estimate of

value.
Appropriate for valuing companies with large debt
burden: while earnings might be negative, EBIT is likely
to be positive.
Gives a measure of cash flows that can be used to
support debt payments in leveraged companies.

2001 M. P.

University of

Heuristic methods: drawbacks

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While heuristic methods are simple, all of them share

several common disadvantages:

they do not accurately reflect the synergies that may be

generated in a takeover.
they assume that the market valuations are accurate. For
example, in an overvalued market, we might overvalue the
firm under consideration.
They assume that the firm being valued is similar to the
median or average firm in the industry.
They require that firms use uniform accounting practices.

2001 M. P.

University of

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Valuation: DCF method

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Here we follow the discounted cash flow (DCF)

technique we used in capital budgeting:

Estimate expected cash flows considering the synergy in a

takeover
Discount it at the appropriate cost of capital

2001 M. P.

University of

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DCF methods: Starting data

Free Cash Flow (FCF) of the firm

Cost of debt of firm
Cost of equity of firm
Target debt ratio (debt to total value) of the firm.

2001 M. P.

University of

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Template for Free Cash Flow

Income Statement

Working capital
Year
Revenue
Costs
Depreciation of equipment
Profit/Loss from asset sales
Taxable income
Tax
Net oper proft after tax (NOPAT)
Depreciation
Profit/Loss from asset sales
Operating cash flow
Change in working capital
Capital Expenditure
Salvage of assets
Free cash flow

2001 M. P.

Noncash item
Noncash item

Adjustment for
for non-cash

Capital items

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Template for Free Cash Flow

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The goal of the template is to estimate cash flows, not profits.

Template is made up of three parts.

An Income Statement
Adjustments for non-cash items included in the Income
statement to calculate taxes
Adjustments for Capital items, such as capital expenditures,
working capital, salvage, etc.
The Income Statement portion differs from the usual income
statement because it ignores interest. This is because, interest,
the cost of debt, is included in the cost of capital and including it
in the cash flow would be double counting.
Sign convention: Inflows are positive, outflows are negative.
Items are entered with the appropriate sign to avoid confusion.

2001 M. P.

University of

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Template for Free Cash Flow

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There are four categories of items in our Income Statement.

While the first three items occur most of the time, the last one is
likely to be less frequent.

Revenue items
Cost items
Depreciation items
Profit from asset sales

Adjustments for non-cash items is to simply add all non-cash

items subtracted earlier (e.g. depreciation) and subtract all noncash items added earlier (e.g. gain from salvage).
There are two type of capital items

Fixed capital (also called Capital Expenditure (Cap-Ex), or Property,

Plant, and Equipment (PP&E))
Working capital

2001 M. P.

University of

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Template for Free Cash Flow

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It is important to recover both at the end of a finite-lived project.

Salvage the market value property plant and equipment

Recover the working capital left in the project (assume full recovery)

2001 M. P.

University of

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Template for Free Cash Flow

Taxab le income = Revenue - Costs - Depreciation + Profit from asset sales

NOPAT = Taxab le income - Tax
Operating cash flow = NOPAT + Depreciation - Profit from asset sales
Free cash flow = Operating cash flow - Change in working capital - Capital Expenditure +
Salvage of equipment - Opportunity cost of land + Salvage of land
Adjustment of noncash items:
Add the noncash items you sub tracted earlier and sub tract the noncash items you added earlier.

2001 M. P.

University of

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Estimating Horizon

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For a finite stream, it is usually either the life of the

product or the life of the equipment used to

manufacture it.
Since a company is assumed to have infinite life:

Estimate FCF on a yearly basis for about 5 10 years.

After that, calculate a Terminal Value, which is the ongoing
value of the firm.

Terminal value is calculated one of two ways:

Estimate a long-term growth and use the constant growth
perpetuity model.
Use a Enterprise value to EBIT multiple, or some such
multiple

2001 M. P.

University of

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Costs of debt and equity

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Cost of debt can be approximated by the yield to

maturity of the debt.

If it is not directly available, check the bond rating of
the company and find the YTM of similar rated bonds.
Cost of equity

CAPM

Findeand calculate required re.

Use Gordon-growth model and find expected re. Under the

assumption that market is efficient, this is the required re.

2001 M. P.

University of

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Model of a Firm

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Value from
Operations
Enterprise value

Value from
investments
Value generated

FIRM
DEBT and
other
liabilities
2001 M. P.

Equal if debt
is fairly priced

Value to Equity

EQUITY
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Value of equity

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Value of equity

= Enterprise value
+ Value of cash and investments
- Value of debt and other liabilities

2001 M. P.

University of

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