5. Valuation Methods: An Overview
Several valuation methods are available, depending on a company’s industry, its characteristics (for example, whether it is a start-up or a mature company), and the analyst’s preference and expertise. In this chapter and the rest of the book, we focus on the mainstream valuation methods. These methods are classified into four categories, based on two dimensions. The first dimension distinguishes between direct (or absolute) valuation methods and indirect (or relative) valuation methods; the second dimension separates models that rely on cash flows from models that rely on another financial variable, such as sales (revenues), earnings, or book value.
As their name indicates, direct valuation methods provide a direct estimate of a company’s fundamental value. In the case of public companies, the analyst can then compare the company’s fundamental value obtained from that valuation analysis to the company’s market value. The company appears fairly valued if its market value is equal to its fundamental value, undervalued if its market value is lower than its fundamental value, and overvalued if its market value is higher than its fundamental value. In contrast, relative valuation methods do not provide a direct estimate of a company’s fundamental value: They do not indicate whether a company is fairly priced; they indicate only whether it is fairly priced relative to some benchmark or peer group. Because valuing a company using an indirect valuation method requires identifying a group of comparable companies, this approach to valuation is also called the comparables approach.
Exhibit 1.1 provides an overview of the mainstream valuation methods.
Exhibit 1.1. Overview of Valuation Methods
Direct (or Absolute) Valuation Methods
Relative (or Indirect) Valuation Methods
Valuation methods that rely on cash flows
Discounted cash flow models:
Valuation methods that rely on a financial variable other than cash flows
Economic income models:
Price-to-earnings ratios (P/E ratio, P/EBIT ratio, and P/EBITDA ratio)
Enterprise value multiples:
* E stands for earnings; EBIT for earnings before interest and taxes; EBITDA to earnings before interest, taxes, depreciation, and amortization; and EV for enterprise value.
Academicians and practitioners are in relative agreement on what drives a company’s fundamental value: its future cash flows. However, no consensus has settled on what drives a company’s share price. In today’s global economic environment, it would be naïve to suggest that any single factor drives share prices. Indeed, the proliferation of valuation methods partly reflects the financial community’s inability to agree on exactly which factors are the primary drivers of share prices—cash flows, sales, accounting earnings, book value, or economic income. The dominant viewpoint is that changes in share prices are most closely related to changes in future cash flows, with all else being equal. This is the viewpoint this book endorses.
We now turn to a closer examination of the valuation methods presented in Exhibit 1.1.
5.1. Relative Valuation Methods
The notion that “time is money” or, stated alternatively, that “time is an expensive and limited commodity” is one of the principal reasons for relative valuation methods. Other reasons are that they are simple to apply and easy to understand. In essence, relative valuation methods give corporate executives and analysts a “quick and dirty” way to estimate the value of a company.
Relative valuation methods rely on the use of multiples. A multiple is a ratio between two financial variables. In most cases, the numerator of the multiple is either the company’s market price (in the case of price multiples) or its enterprise value (in the case of enterprise value multiples). The enterprise value of a company is typically defined as the market value of its capital (debt and equity), net of cash. The denominator of the multiple is an accounting metric, such as the company’s earnings, sales, or book value. Multiples can be calculated from per-share amounts (market price per share, earnings per share, sales per share, or book value per share) or total amounts. Note that whether the analyst uses per-share amounts or total amounts does not affect the multiple, as long as the same basis is used in both the numerator and the denominator.
5.1.1. Price Multiples
The most popular price multiples are earnings multiples. The price-to-earnings (P/E) ratio, which is equal to a company’s market price per share divided by its earnings per share (EPS), is the most widely used earnings multiple. It provides an indication of how much investors are willing to pay for a company’s earnings. For example, a company whose P/E ratio is 15 is said to be selling for 15 times earnings; put another way, investors are willing to pay $15 for each $1 of current or future earnings. Companies with high earnings growth prospects usually carry high P/E ratios because these companies are expected to be able to reward investors with a quicker and larger return on their investment in the form of dividends, increase in share price, or both.
Because the earnings of a company are influenced to varying degrees by how the company is financed (with debt or with equity) and where it pays income taxes, some analysts have turned to a variant of the P/E ratio that removes the effect of a company’s capital structure and income taxes on its earnings. This variant is the price-to-earnings before interest and taxes (P/EBIT) ratio. Still other analysts, worried about the distortive effect on earnings of accounting policies with respect to the depreciation of tangible assets and the amortization of intangible assets, prefer to use the price-to-earnings before interest, taxes, depreciation, and amortization (P/EBITDA) ratio. The P/EBITDA ratio is also popular because of the close relationship between a company’s EBITDA and its cash flow from operations.
The P/E, P/EBIT, and P/EBITDA ratios all require positive accounting earnings. But not all companies are profitable—particularly young ones. For companies that are operating at a loss, analysts must find an alternative to accounting earnings. The most popular alternative is sales, which leads to the price-to-sales (P/Sales) ratio. The P/Sales ratio is useful in the early stages of a company’s life cycle, when marketplace acceptance and growth in market share are considered to be the two best indicators of the company’s likely future operating earnings and cash flows.
Another price multiple is the price-to-book (P/Book) ratio. It indicates the relative premium that investors are willing to pay over the book value of their equity investment in a company. Unfortunately, a company’s book value is highly sensitive to accounting standards and management’s accounting decisions. For this reason, the P/B ratio is used selectively; realistically, it is neither a valid nor viable valuation method for most companies, except perhaps for financial institutions and insurance companies. These companies have highly liquid assets and liabilities on their balance sheets, which makes book values more realistic proxies for market values.
In contrast to the previous five multiples, the last one is based on cash flows. Because cash flows are less sensitive than earnings to accounting choices and potential accounting manipulations, some analysts prefer to base their valuation on the price-to-cash-flow (P/CF) ratio than on the P/E, P/EBIT, or even P/EBITDA ratios.10 This approach is also consistent with the viewpoint that value is primarily driven by cash flows.
5.1.2. Enterprise Value Multiples
Price multiples are popular with buy-side and sell-side analysts interested in valuing a company’s price per share—that is, the company’s equity value per share.11 In the context of M&As, however, corporate executives and analysts are often interested in assessing a target’s total value, reflecting both debt and equity. In this case, the enterprise value is a better basis for the valuation, hence the reason enterprise value multiples are widely used when valuing an acquisition target.
The most popular enterprise value multiple is the EV/EBITDA multiple, although the EV/Sales multiple can be used for unprofitable companies. For example, an EV/EBITDA multiple of 8 indicates that the acquirer is willing to pay eight times the target’s current or future EBITDA. Many analysts often check that the EV/EBITDA multiple offered to acquire a target is in line with the EV/EBITDA multiples paid in previous acquisitions. Offering an EV/EBITDA multiple that is substantially higher than the average EV/EBITDA multiple for comparable transactions is usually an indication that the acquirer is overpaying for the target.
5.2. Direct Valuation Methods
Unlike the relative valuation methods, direct valuation methods give investors an explicit equity value per share or share price objective. Preeminent among the group of direct valuation methods are the discounted cash flow (DCF) models.
5.2.1. Discounted Cash Flow Models
DCF models are premised on one of the most fundamental tenets of corporate finance: The value of a company today is equal to the present value of the future (but uncertain) cash flows to be generated by the company’s operations, discounted at a rate that reflects the riskiness (or uncertainty) of those cash flows.
The most widely used version of the DCF model is sometimes referred to as the free cash flow to the firm model, or weighted average cost of capital model. It provides an estimation of the company’s total value, based on its free cash flows (FCFs) to the firm discounted at the weighted average cost of capital (WACC). The FCFs of the firm are the cash flows from operations available to all capital providers, net of the required capital investments necessary to maintain the company as a going concern. The WACC reflects the hurdle rate that providers of capital require, based on the risk they face from investing in the company. The equity value per share—that is, the value accruing to the common (or voting) shareholders—is given by the operating value of the company minus the value of any claims on the company’s cash flows by debt holders, preferred shareholders, noncontrolling (minority) interest shareholders, and any contingent claimants.
A variant is the free cash flow to equity model, which provides a direct estimate of a company’s equity value per share. Instead of relying on the FCFs available to all capital providers, it considers the FCFs available to equity holders: the FCFs to the firm minus all the cash flows owed to claimants other than common shareholders. Because the focus is on equity holders, the discount rate is the cost of equity, or the hurdle rate for common shareholders.
The FCF to the firm and FCF to equity models are highly effective valuation methods, particularly when the capital structure of a target is expected to remain stable over time. Some acquisitions, however, are predicated on material changes in capital structure, as in the case of an LBO. In these situations, the adjusted present value (APV) model is easier to implement than the other DCF models. Under the APV model, the value of a target is decomposed into two components: the value of the company assuming that it is financed entirely with equity, and the value of the tax shield (benefits) provided by a company’s actual (or expected) debt financing. Because interest is tax deductible, using financial leverage increases a company’s value by reducing its cash outflow for income taxes. As a company’s capital structure changes over time, the first component (the unleveraged, or unlevered, value) is unaffected; the change in financial leverage affects only the second component (the interest tax shield), which is relatively straightforward to estimate.
5.2.2. Non Discounted Cash Flow Models
Real option analysis is another valuation method that relies on cash flows, although it is grounded in option-pricing models instead of DCF models. Analysts rarely use real option analysis to value an entire company. However, this valuation method proves useful when a company has investment opportunities that have option-like features; these features are usually difficult, if not impossible, to capture using DCF models. For example, a company might have rights (but not obligations) to delay investments, expand into new markets, redeploy resources between projects, or exit investments. These rights are valuable options, particularly in an uncertain environment. Real option analysis, which applies to real assets some of the techniques used for valuing financial options, enables analysts to value the wide range of rights a company has.
Economic income models, also called residual income models, differ from DCF models and real option analysis, in that they rely not on cash flows, but on earnings to estimate a company’s fundamental value. However, in contrast with price and enterprise value multiples that are based on accounting earnings, economic income models rely on economic income. Economic income is usually defined as net income minus a charge for using equity—one of the issues with accounting earnings such as net income is that they include a charge for using debt (interest expense), but not for using equity. The principle behind economic income models is that a company that produces positive economic income creates shareholder value. Consequently, it should be rewarded with a higher share price. The most popular economic income model is economic value analysis, although other versions are also available.
Academicians agree that, in theory, the FCF to the firm, FCF to equity, APV, and economic income models are equivalent, provided, of course, that the models use the same assumptions. In practice, however, differences arise, primarily because of implementation issues. Thus, as we review the different valuation methods in Chapters 3, “Traditional Valuation Methods,” and 4, “Alternative Valuation Methods,” we address the major issues an analyst faces when using relative and direct valuation methods.
5.3. The Use of Valuation Methods
Imam, Barker, and Clubb (2008) conducted semi-structured interviews with sell-side and buy-side analysts in the United Kingdom to determine which valuation methods analysts used, why they used them, and how they used them. Their results showed that
- The two most widely used valuation methods are the P/E ratio and the FCF to the firm model. In contrast, few analysts used economic value analysis, multiples based on book values (whether price or enterprise value multiples), or the P/Sales ratio.12
- Approximately 60 percent of the analysts expressed a strong preference for cash flow–based valuation methods, particularly buy-side analysts. However, most analysts admit that they often complement their cash flow–based analysis with a multiples-based analysis.
- Some valuation methods are sector specific. For example, the P/B ratio and EV/Sales ratios are rarely used, except to value financial institutions and retailers, respectively.
The results of this survey are consistent with our own experience. This is the reason we have classified the FCF to the firm model and the P/E ratio as “traditional” valuation methods in this book, and we cover them both thoroughly in Chapter 3. Although other valuation methods are less often used, they are part of the analyst toolbox. Thus, we also discuss these “alternative” methods in Chapter 4, albeit less thoroughly.