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If you are interested in learning how to value a company using different valuation methods, you are in the right place. Evaluating the intrinsic value of stocks is not an easy task, and one of the main difficulties for many analysts is choosing the correct valuation method.
It's very important to master multiple valuation models to find the intrinsic value of a business. Being biased towards one particular methodology could negatively impact investment decisions and result in capital losses and missed opportunities! This article will discuss the most popular valuation methods to find a company's fair value.
1# Valuation Method: DCF Analysis
Discounted Cash Flow (DCF) valuation is one of the most popular methods used by equity analysts to estimate a company's fair value based on forecasts of how much cash flow it will generate in the future.
So, the first step to build a DCF valuation model is forecasting future free cash flows. Since FCF can be challenging to estimate directly, it is common practice to forecast revenue first and arrive at FCF by making the required adjustments.
Since we can't forecast cash flows perpetually, most analysts project them for five or ten years and then estimate a Terminal Value, which represents the value of the business at the end of the forecast period.
Once we've forecasted the company's future free cash flows and its terminal value, we have to find their present value by discounting them back to the present using our required rate of return. The resulting value is the amount an investor needs to pay for the business to achieve their desired rate of return.
Any price lower than the DCF value will result in a higher rate of return. On the flip side, if the investor pays more than the DCF value, he should expect to get a lower rate of return. Below is an example of Apple's DCF analysis results. According to the model, Apple's fair value is equal to $84.51, representing a -29% downside from the current price of $119.03.
2# Valuation Method: Comparable Analysis
Comparable Companies Analysis, otherwise known as “comps,” is a widely used valuation method that estimates a business’s fair value by comparing its valuation metrics with its peers, which are similar companies selected based on their industry, size, growth, and various financial metrics.
The comparable analysis method works under the assumption that similar companies should trade at similar valuation multiples. Below is an example of Apple's comparable analysis summary using different EBITDA multiples. According to the model, Apple's fair value is equal to $82.44, representing a -31% downside from the current price of $119.03.
3# Valuation Method: Dividend Discount Model
Among the various valuation techniques used for valuing a business, the dividend discount model is another reliable method that is used to predict the value of dividend-paying companies. The Dividend Discount Model is based on the assumption that a stock's fair value is equal to the sum of its future dividends discounted back to the present.
Below is an example of Apple's dividend discount model (stable growth) summary. According to the model, Apple's fair value is equal to $85.34, representing a -28% downside from the current price of $119.03.
4# Valuation Method: Precedent Transaction
The precedent transaction valuation method attempts to estimate a business’s fair value by analyzing the price paid for the acquisition of similar companies in past M&A transactions. In this way, the analyst can estimate what a share of the company’s stock is going to be worth during an acquisition.
The precedent transaction valuation is very similar to the comparable companies analysis—with both approaches, the company's fair value is estimated by comparing its valuation multiples to other businesses. While both involve a relative valuation approach, the main difference is that with peer analysis the analyst takes into consideration current valuation ratios, while in precedent transactions the analyst should also consider a takeover premium.
For obvious reasons, one of the most important factors when using this valuation method is identifying relevant precedent transactions, which in some industries don't take place very often. Furthermore, one more difficulty consists of finding reliable information on precedent M&A transactions and creating a reliable estimate on premiums and multiples.
The Football Field Chart
One of the most effective ways to summarize the different estimates obtained using all the valuation methods is to develop a football field chart. It is called a football field chart because the bars used on the chart resemble the yard lines on a football field and because bankers tend to like making sports analogies.
The main goal of using this method is to summarize and sanity-check various methodologies and see how they compare to each other. The purpose of the football field chart is to show just how much a potential buyer will be ready to pay for a particular business, whether they are acquiring a single share, part of it, or all of it.
Below is an example of Apple's football field chart showing the various fair value estimates we obtained using different valuation methods. According to the models, the average of Apple's fair values is $87.14, representing a -27% downside from the current price of $119.03.