Capitalism is a system in which private owners control private property and let market forces- supply and demand set prices. To make money in such a system, rational allocation of capital is the only legitimate route to success. Being able to value assets, market opportunities and businesses is therefore a cornerstone of modern civilisation!

As an investor, company valuation or as a business manager, project appraisal (i.e. valuation)  underpins all decision-making processes, ranging from share portfolio investment decisions to mergers and acquisitions, to capital investment. It is a systematic approach to determining the intrinsic worth or value of an asset, business, or company. Are markets efficient? Are assets always at about their right value? History and experience show us that disparities in valuations can persist in and between markets for long times. These disparities create opportunities. We will look at the main valuation techniques used by investors exploring their definitions, types, models, and the circumstances under which it is performed, providing a comprehensive understanding of this critical financial concept.

Valuation is the process of estimating the worth or value of an asset, business, or company based on various factors, such as its current and projected financial performance, cashflow, market conditions, industry trends, and competitive landscape. It is a multifaceted exercise that involves analysing both qualitative and quantitative data to arrive at a defensible and well-reasoned estimate of value.

Article Contents

• When do Financiers Perform Valuations?
• Valuation Methods
  • Share Valuation
  • Asset Value – Commercial Property
  • Mergers and Acquisitions – Precedent Transactions
• Examples and Case Studies for Valuation
• Limitations and Challenges of Valuation Methods
• Common Mistakes and Pitfalls in Valuation
• Valuation Standards and Regulations

When do Financiers Perform Valuations?

Valuations are conducted in a variety of scenarios within the finance industry. Some of the most common instances include:

• Mergers and Acquisitions: Valuations are essential when companies are considering acquiring or merging with another business. This process can be split into three steps: firstly, the calculation of a standalone valuation. Secondly, we can calculate a “management premium” – how much more valuable will the company if we the acquire and manage it better and achieve similar profitability to our existing business? Thirdly we can value the value of synergies. The challenge for a bidder is then to get a deal without giving away all of the value of the potential vendors shareholders.
• Investment Decisions: Investors, such as private equity firms, venture capitalists, and asset managers, rely on valuations to assess the potential return on investment and make informed decisions about which companies or assets to invest in.
• Initial Public Offerings (IPOs): When a private company decides to go public and offer shares on a stock exchange, valuations are performed by all the parties involved: the corporate finance advisers will suggest a range of valuation at the beginning of the process; analysts initiating coverage will, as the issue is launched, recommend a price target; individual portfolio investors will do their own valuation and bid for stock accordingly.  This process of “price discovery” is how we find the market’s consensus bid/valuation of the company and set the price of the issue.
• Restructuring and Reorganization: In cases of financial distress, companies will undergo restructuring or reorganization. In this situation, investors will value the different loans and bonds outstanding at the company to estimate their likely recovery on each different instrument – secured loans, senior unsecured loans and bonds, subordinated debt and so on.
• Tax Planning and Compliance: Valuations are often required for tax purposes, such as determining the value of grants or share options as part of executive remuneration; the value of assets transferred in estate planning, gift taxation. Often the valuations are a matter of fact – the sale price of a share. The valuation of share options requires a subjective valuation using an option pricing model. So do assets transferred to beneficiaries without consideration (payment).

Valuation Methods

Rather than talking generically, let’s talk about the standard approaches taken in different sectors:

Share Valuation

For most non-financial companies, such as retailers, manufacturers, mobile phone companies, analysts will use three broad methods

• Comparable company analysis: This involves looking at valuation multiples for similar companies and making the argument for a relative value for your company: “the peers trade on an average p/e of 12 times, this company is undervalued as it trades on 11X”. This isn’t as straightforward as it looks as we will have to consider the relative growth rates, business strengths of the peers and different make up of their businesses. The company trading on 12X might be valued this way because it’s faster growing and is better run. You also won’t just look at one metric like P/E, but you’ll look across a range, like EV/EBITDA.
• Discounted Cash Flow: this is considered a more fundamental method – we forecast post-tax pre-financing cashflows and discount at a weighted average cost of capital.
• LBO Valuation: using an LBO structuring model, the analyst will estimate how much a private equity firm might be willing to pay, given its typical financing methods and return objectives.

The relative weight that analysts put on these methods vary from sector to sector:  in supermarkets many analysts rely heavily on DCF.  In oil exploration companies, analysts value the oil in the ground by forecasting production and valuing the oil produced at $50 per barrel and discounting the cashflow from sales.

What do you do if you value a company two ways and get very different answers? DCF can help an investor keep their feet on the ground. DCF is Warren buffet’s touchstone: quoting in part his friend Ben Graham, Warren said:

“The market may ignore business success for a while, but eventually will confirm it.”

As Ben said:

“In the short run, the market is a voting machine but in the long run it is a weighing machine.”

The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage – it may give us the chance to buy more of a good thing at a bargain price.

Asset Value – Commercial Property

In commercial property investment, both listed and unlisted, official valuers and investors value properties using discounted cashflow: the rental income from a rented property is treated as a perpetuity and discounted by dividing the annual rent by the required rental yield.  This gives the capital value of the property. Like with equities there is more than one way to value a property. Perhaps if you terminate the leases, knock down, refurbish, and add a couple of extra floors, maybe the property will be even more valuable, when relet with more floor space and a higher rent…?

Mergers and Acquisitions – Precedent Transactions

In principle, the precedent transactions method for valuing a company is straightforward. WE look at the prices paid for companies in recent takeover deals and infer valuation multiples – EV/EBITDA typically for our business.

This process reveals a different paradigm for valuation of private and listed companies: in listed company transaction a “control premium” gets paid by the acquirer. In private companies, valuation multiples tend to be lower. Typically, bidders will offer at least a 25% premium to gain the interest of shareholders. Depending on market conditions and individual deals, the premium can be much higher:  During the Global Financial crisis, acquirers in the UK typically paid premia of very 60%! In the 2020s we are seeing these high premia being offered and paid for UK listed companies: G4S in 2021 was acquired for a 69% premium, in early 2024, Blackstone offered over a 50% premium to acquire Hipgnosis song fund. In early 2024EQT has offered a 73% premium to acquire Keynote Studios!

In all of these cases you could argue that the companies were all undervalued by UK investors.  Interestingly if we look at Hipgnosis (LSE: SONG), it’s assets – song rights – are valued officially by discounting expected future royalty payments. Before the bid, the shares were trading at around a 30% discount to their Net asset value per share. The Blackstone bid is at only a 7.5% premium. So perhaps Blackstone’s bid is fair?

In listed company deals precedents create an investor expectation of the premium they should receive.

In private company deals, precedents re difficult to use reliably: no valuation data is typically published, so multiples must be inferred from potentially very out of date publicly published accounts. If a deal is a “spin -out,” i.e. the separation and sale of a division, there may never have been any public data from which to infer a multiple. In the mid-cap space, the actual levels of valuation in these private deals tends to be valuable proprietary knowledge held by the leading corporate finance advisers.

There is a broader issue with precedents which is timeliness and relevance: how many similar companies have been sold recently? If precedents are too old, they may represent valuation levels from a time when market conditions were totally different. High UK premia reflect the generally low valuation for the UK stock market, which trades on an average P/E of 12X, compared with a multiple of over 20X for the US market (early 2023)!

Examples and Case Studies for Valuation

Example 1: Valuation of a Publicly Traded Company

Suppose an investor is considering investing in ABC Corporation, a publicly traded company in the technology sector. To determine the appropriate value of ABC Corporation, the investor may use a combination of valuation methods, such as the company comparables method and the DCF analysis method.

Using the company comparables method, the investor would identify a group of similar publicly traded companies in the technology sector and analyse their financial ratios and multiples, such as P/E ratios and EV/EBITDA multiples. The investor would then apply these multiples to ABC Corporation’s financial metrics to estimate its value relative to its peers.

Additionally, the investor could perform a DCF analysis by forecasting ABC Corporation’s future cash flows, determining an appropriate discount rate based on the company’s risk profile and market conditions, and calculating the present value of those discounted cash flows. This would provide an estimate of the company’s intrinsic value based on its future earnings potential.

By combining the results of these valuation methods and considering other qualitative factors, such as the company’s competitive position, management team, and growth prospects, the investor can arrive at a well-rounded assessment of ABC Corporation’s value and make an informed investment decision.

Example 2: Valuation of a Private Company for Acquisition

Consider a scenario where XYZ Corporation, a large publicly traded company, is interested in acquiring a private company, Alpha Inc., which operates in the same industry. XYZ Corporation would need to perform a valuation of Alpha Inc. to determine an appropriate acquisition price.

In this case, the precedent transactions method may be particularly useful, as there may be limited publicly available financial information for Alpha Inc. as a private company. The valuation team at XYZ Corporation would research recent mergers and acquisitions involving similar companies in the same industry and analyse the valuation multiples and metrics used in those transactions.

Additionally, the valuation team may employ the DCF analysis method by forecasting Alpha Inc.’s future cash flows based on its historical performance and growth projections. They would then determine an appropriate discount rate based on the risk profile of Alpha Inc. and its industry and calculate the present value of those discounted cash flows to estimate the company’s intrinsic value.

By considering the results of these valuation methods, along with other factors such as potential synergies between the two companies and Alpha Inc.’s strategic fit within XYZ Corporation’s overall business plan, XYZ Corporation can make an informed decision regarding the appropriate acquisition price for Alpha Inc.

These examples illustrate the practical application of valuation methods in real-world scenarios and highlight the importance of using multiple valuation techniques and considering various factors to arrive at a comprehensive and well-reasoned valuation.

Limitations and Challenges of Valuation Methods

While valuation methods provide a structured approach to estimating the worth of an asset or company, they are not without limitations and challenges. Some of the key issues include:

1. Data Availability and Reliability: Valuation models rely heavily on historical financial data and future projections. In situations where data is limited, incomplete, or unreliable, the accuracy of the valuation may be compromised. This is particularly challenging when valuing private companies or early-stage startups with limited operating history.[4]
2. Assumptions and Subjectivity: Valuation models require numerous assumptions about future growth rates, discount rates, and risk factors. These assumptions can be subjective and may vary among different valuation professionals, leading to differing valuation outcomes. It is essential to carefully assess and justify the assumptions used in the valuation process.[5]
3. Market Volatility and Uncertainty: Valuations are influenced by prevailing market conditions and investor sentiment. In times of economic uncertainty or market volatility, valuation multiples and assumptions may fluctuate rapidly, making it challenging to arrive at a stable and reliable valuation.[6]
4. Industry-Specific Considerations: Each industry has its own unique characteristics, risk factors, and value drivers. Valuation professionals must have a deep understanding of the industry-specific dynamics and adapt their valuation approaches accordingly. Failing to account for industry nuances can lead to inaccurate or misleading valuations.[7]

Common Mistakes and Pitfalls in Valuation

To ensure the integrity and reliability of valuations, it is crucial to avoid common mistakes and pitfalls. Some of these include:

1. Over-reliance on a Single Valuation Method: Using a single valuation method can lead to biased or incomplete results. It is essential to employ multiple valuation techniques and triangulate the results to arrive at a more robust and defensible valuation.[8]
2. Neglecting Qualitative Factors: Valuation is not solely a quantitative exercise. Qualitative factors, such as management quality, competitive advantages, and market positioning, can significantly impact a company’s value. Ignoring these factors can result in an incomplete or misleading valuation.[9]
3. Failing to Conduct Sensitivity Analysis: Valuations are based on numerous assumptions and inputs. Conducting sensitivity analysis helps assess the impact of changes in key assumptions on the valuation outcome. Neglecting to perform sensitivity analysis can lead to an over-reliance on a single set of assumptions and a lack of understanding of the valuation’s sensitivity to changes in inputs.[10]
4. Ignoring the Purpose of the Valuation: The purpose of the valuation should guide the choice of valuation methods and assumptions. For example, a valuation for tax purposes may require different considerations compared to a valuation for mergers and acquisitions. Failing to align the valuation approach with the intended purpose can lead to inappropriate or misleading results.[11]

Valuation Standards and Regulations

Valuation standards and regulations vary across different countries and jurisdictions. However, there are some widely recognized standards and guidelines that aim to promote consistency, transparency, and best practices in the valuation profession. Some of these include:

1. International Valuation Standards (IVS): The International Valuation Standards Council (IVSC) develops and maintains a set of global valuation standards known as the IVS. These standards provide a framework for conducting valuations and aim to enhance the consistency and comparability of valuations across borders.[12]
2. Generally Accepted Valuation Principles (GAVP): GAVP are a set of principles and best practices that guide the valuation process in the United States. These principles emphasize the importance of independence, objectivity, and the use of appropriate valuation methodologies.[13]
3. Regulatory Requirements: Depending on the jurisdiction and the purpose of the valuation, there may be specific regulatory requirements that must be adhered to. For example, valuations for financial reporting purposes may need to comply with accounting standards such as the International Financial Reporting Standards (IFRS) or the Generally Accepted Accounting Principles (GAAP).[14]

It is essential for valuation professionals to stay informed about the relevant standards and regulations applicable to their jurisdiction and the specific valuation engagement. Adhering to these standards helps ensure the quality, reliability, and acceptability of valuation results.

References:

[1] Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset (Vol. 666). John Wiley & Sons.

[2] Geltner, D., Miller, N., Clayton, J., & Eichholtz, P. (2014). Commercial real estate analysis and investments. OnCourse Learning.

[3] Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: measuring and managing the value of companies (Vol. 499). John Wiley & Sons.

[4] Damodaran, A. (2009). Valuing young, start-up and growth companies: estimation issues and valuation challenges. SSRN Electronic Journal.

[5] Fernández, P. (2007). Company valuation methods. The most common errors in valuations. IESE Business School, 1-27.

[6] Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: measuring and managing the value of companies (Vol. 499). John Wiley & Sons.

[7] Hitchner, J. R. (2017). Financial valuation: Applications and models. John Wiley & Sons.

[8] Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset (Vol. 666). John Wiley & Sons.

[9] Fernández, P. (2007). Company valuation methods. The most common errors in valuations. IESE Business School, 1-27.

[10] Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: measuring and managing the value of companies (Vol. 499). John Wiley & Sons.

[11] Hitchner, J. R. (2017). Financial valuation: Applications and models. John Wiley & Sons.

[12] International Valuation Standards Council. (2020). International Valuation Standards.

[13] American Society of Appraisers. (2009). ASA business valuation standards.

[14] Catty, J. P. (2010). Guide to fair value under IFRS. John Wiley & Sons.