Understanding Valuation: 3 Most Used Methods

When you are selling a company, it is important to know what range you are in with regard to the value of your company. 31% of all deals that are not transacted are because of valuation gaps in pricing between the seller and the buyer. With that said, a seller should know what potential methods a buyer would use to value their company. Pepperdine University published a report called "2019 Private Capital Markets Report" wherein a part of it had 92 investment bankers surveyed to ask about the industry and its trends. The report shows that the top three valuations methods for valuing private companies are the discounted future earnings method, guideline company transactions method, and the capitalization of earnings method.

1. Discounted Future Earnings: Otherwise known Discounted Cash Flow Analysis or DCF is the most used method as 36% of respondents report using this technique. It is the process of using future cash flows to value your company. You would do this by calculating the free cash flow of your company over the next 5-10 years and discounting that back to present value. Then you would take the final year of your projections and use a multiple or perpetual growth percentage to calculate the terminal (or residual) value. Add the two numbers together and you should get the value of the firm based on the model.

2. Guideline Company Transactions Method: This method is more commonly known as the Comparative Company Method or the Market Method and accounts for about 20% of the respondents preferred valuation method. For this technique, you would take a universe of comparable companies that have sold and compare their EBITDA, revenue, or net income multiples for which they sold for. It is critical that you have enough companies in your comparable analysis so no single company transaction would skew the data, so having between 7-12 companies is a good basis. Furthermore, these companies must be similar to the company being valued, meaning they should have similarities with size, revenue, EBITDA, geography, etc. Once you have the list of companies and their selling prices and multiples, you can use that data to find the industry average and apply it to your given company. 

3. Capitalization of Earnings Method: Here we have the third most used valuation method at 17% based on the report. You can think of it as a simpler DCF, where you compute the expected cash flow from just a single period using a long-term growth rate as a reliable estimate for future growth. Once you have expected cashflow, subtract that growth rate from the discount rate to achieve your capitalization rate. Finally, divide your cashflow number by your capitalization rate to find the output of your valuation. 

Main Differences

While all are valid ways to value a company, there are stark differences with what they entail and the values they give back. Using comparable transactions will most likely give you the highest valuation as the price would have the premium built in to compensate shareholders above intrinsic value. While this could be easier than the complexities within the assumptions of a DCF model (growth rate, discount rate, terminal value, tax rate, etc.) it could sometimes be hard to find companies that fit your specific companies mold. A DCF requires fewer companies to pull examples from but offers much more flexibility due to these assumptions, though this does leave plenty of room for user error by inputting incorrect forecasts, thus yielding incorrect returns. Using capitalization of earnings is a simpler method that would yield lower valuations due to a hypothetically conservative growth method, it can be an easiest way to get a valuation out of the three covered.