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What are the methods of valuation of companies?

The valuation of a company is a delicate exercise. A science that is not exact and complex due to the multitude of elements to consider, this financial analysis is often associated with tough negotiations between the buyer and the seller. It is due to the asymmetry of information between these two actors and the dichotomy between their expectations and their respective understandings of the company and its future. The purpose of a valuation is to determine the Company's Value, independently of the financing structure chosen by the manager. Thus, the objective is to get closer to the company's intrinsic value, that is to say, the value that an acquirer would be ready to pay to know of all the information available on the company.

Before the valuation exercise and the study of the company's financial statements, it is necessary first to understand its business model, organization, and environment. This preliminary step necessarily induces a good knowledge of the business sector in which the company operates. In this regard, it is important to call on an expert who has a perfect understanding of the business environment and its market. Secondly, it is necessary to analyze the company's historical financial performance and its forecast of activity, taking into account future trends in the market in which it operates.

Several valuation techniques exist and can be applied depending on the profile of the company. The objective is to provide stakeholders with a base price that will serve as a reference in the conduct of negotiations. Each method has its own advantages and disadvantages. It is for those who have the mission to evaluate a company to select the most relevant approach according to the nature of the company and the purpose of the financial evaluation.

It is important to remember that the valuation exercise aims to define a range of values ​​and not an exact amount. Finally, the valuation of a company does not depend solely on the method chosen. Several elements, such as the valuation of synergies or the market situation, can induce a buyer to pay a premium compared to the intrinsic value of the company.

Company valuation by the valuation method by multiples

The first valuation method that we are going to develop is the multiples method. This approach's methodological basis is simple, and based on the principle of arbitrage: two completely similar assets must be offered at the same price. Otherwise, the possibility of arbitrage and the risk-free gain is possible. Thus, two companies operating in the same sector, having an identical level of turnover and whose business model is similar, should have a similar multiple applied and thus have a valuation close to each other.

There are two types of multiples: multiples of comparable companies or “market multiples” (Comparable Company Analysis) and multiples linked to comparable transactions (Precedent Transactions Analysis).

We will first talk about the multiples of comparable companies that allow us to assess the value of the securities of an unlisted company, by comparing its financial aggregates with those of similar companies listed on the stock exchange.

Enterprise value can relate to several types of financial aggregates depending on the specifics of the business sector:

- Turnover (CA)

- Gross operating surplus (EBITDA) or Earnings Before Interests Taxes Depreciation and Amortization (EBITDA)

- The operating result (REX) or Earnings Before Interests and Taxes (EBIT)

The value of equity relates to aggregate after payment of financial interest, typically the Net Income. We then speak of the “Price / Earnings ratio  " or " P / E ratio."

Before calculating the multiple, you must first identify the panel of listed companies that have a maximum of similarities with the one you want to evaluate to create a representative sample (Peer Group). 

These similarities can relate to several aspects of the company, such as its activity, level of turnover, geographical location, growth rate, or even financial structure. The company's valuation will be all the more relevant as the comparable companies selected have similar characteristics. Once the sample of comparable companies has been established, it is necessary to relate the Enterprise Value of each company selected to their respective aggregates (CA, EBITDA, REX), to determine the corresponding multiples. Finally, it is a question of calculating the average or the median of these multiples, which will be applied to the company that one seeks to evaluate.

The second comparative approach corresponds to transaction multiples (Precedent Transactions). As for the multiples of comparable companies, it is necessary to calculate the average or the median of the multiples and to multiply the latter by the aggregates of the company that one seeks to evaluate.

The multiples method's main difficulty lies in researching and collecting information on transactions involving companies with characteristics sufficiently similar to the one we are trying to value. Thus, the more the appraiser can prove strong expertise in the company's business sector and have reliable information on recent and comparable transactions, the more relevant the financial assessment will be.

Company valuation using the discounted cash flow valuation method

This valuation method - known as Discounted Cash-Flow (DCF)  - consists of considering that a company is a today worth all the income it will generate in the future (cash flow), extrapolated to infinity. And it is discounted at the rate of return that an investor might expect. As with previous approaches, the DCF method aims to assess a business's value regardless of its funding structure.

It is first necessary to define, based on a business plan, the company's forecast cash flows (FCFF) over a period generally ranging from 5 to 7 years, a period over which the visibility of future results of the company is realistic. Secondly, the appraiser will have to update these cash flows by first determining the return rate required by potential investors, called the Weighted Average Cost of Capital (WACC).

It will then be necessary to determine a terminal value to materialize the very long-term “sustainability” of the company. The latter will also be discounted at the weighted average cost of capital. Thus, by adding all the discounted FCFFs and adding the discounted terminal value to them, we obtain a company valuation.

This method has several advantages: on the one hand, the information to be collected to calculate the cash flow is easily accessible, making the method applicable to a large panel of companies. On the other hand, this method makes it possible to carry out several scenarios by varying the assumptions used, which provides flexibility to the financial analysis.

However, the DCF has certain drawbacks because the values ​​and growth rates chosen for establishing the forecast data will not necessarily reflect the business's reality. It makes the business's assessment less relevant or even hazardous: the high sensitivity of indicators used (WACC, infinite growth rate, etc.) that can significantly vary the results obtained. Thus, for example, the growth or margin rate assumptions used may have a significant impact on the valuation of the company. In addition, a company is not immune to exceptional events that could impact its future operations, which is likely to invalidate the model adopted. Finally, it is also important to stress that the DCF is not applicable to all companies.

Business valuation using the asset valuation method

The asset valuation method is a balance sheet valuation method and is therefore based on a photograph of the company's assets and debts at a given time. It aims to value a company by separately evaluating each element of the assets and liabilities present in the balance sheet of the company. Once revalued, the liability is subtracted from the asset, which may also be revalued to obtain the revalued net asset, also called equity or netbook asset. By its approach, the heritage method is suitable for companies with a significant balance sheet structure (industry, SCI, financial holding) but not recommended for companies with a low capital intensity such as service companies or start-ups.

The revaluation process is necessary insofar as the book values ​​appearing on a company's balance sheet are recorded at historical cost. Therefore, it will be necessary to re-evaluate the balance sheet items according to the existing assets (net asset value, market value, or even usage value) to obtain a more precise value. In addition to the revaluation, several restatements must be made, such as the reintegration of off-balance sheet items (leases, social liabilities, etc.) or even deletions of items that have no real value to assess a company such as costs.

The main advantage of the heritage method lies in its simplicity of application. The company's value corresponds to the algebraic sum of the various elements of the assets from which is subtracted the revalued value of the liabilities. But like other valuation methods, the heritage approach also has certain drawbacks. Because it is based on a balance sheet approach, it is a static approach that does not integrate the income statement elements, and therefore the profitability of the company or its future potential.

Conclusion

The fair price is the one at which the transferor finds a buyer, and it is the reasonable price, that is to say, argued. Business valuation work is not simply limited to defining a company's value range, and it consists of all in defining a robust argument to justify the valuation adopted. Thus, through his various analytical works, the assessor must highlight all the tangible elements on which his assessment of the company is based and be able to explain and argue it.


Have you any questions? Let us know in the comment box. And for business essayValuation of companies, don’t hesitate to contact us.

Author: Vicki Lezama


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