Valuations are undertaken to determine how much an asset or company is worth and are conducted for a number of purposes: acquisitions, sales (including IPOs), joint ventures, liquidations, for taxation and financial reporting. Knowing the valuation’s purpose, whose perspective it is being conducted from and its premise (e.g. is the company a going concern, is it for liquidation or fire sale) is key. Introducing the ‘market valuations’ and ‘comparable company trading multiples’ valuation methods.
Key learning objectives:
- What are valuations used for and how to approach them?
- Explain the ‘market valuations’ methodology and which companies it is best suited to
- Explain the ‘comparable company trading multiples’ method, its applications, pros and cons?
What are valuations used for and how to approach them?Valuations are conducted for a number of purposes, including:
- Company sales (including IPOs)
- Joint ventures
- Taxation and financial reporting purposes
Explain the ‘market valuations’ methodology and which companies it is best suited toThe market valuations method is relevant for valuing companies listed on a stock exchange; it reflects the value determined between willing buyers and sellers of shares. It is important to distinguish between Equity Value (i.e. the value of the shares of the company, often known as Market Capitalisation) and Enterprise Value (EV) i.e. the total value of the company taking into account equity and debt. Typical metrics used for market valuation are:
- The current share price – EV calculated using the last closing share price
- The 52-week trading range – EV calculated using the lowest/highest share price over 52 weeks
- The 3, 6 and 12-month volume average weighted price (VWAP) – the EV calculated from the average share price over a chosen period weighted by the daily trading volume over that period.
- The range of price targets published by analysts – EV calculated from a range of price targets
Explain the ‘comparable company trading multiples’ method, its applications, pros and cons?The comparable company trading multiples method values companies using key metrics or multiples of comparable companies. The first step is establishing the peer group: similar-sized companies in the same sector in similar geographies with similar products, services, customers and markets. The next step is determining the metric or multiple to use, usually applying a valuation metric (e.g. market cap or EV) to a financial performance metric. The most common financial multiples used include:
- EV/EBITDA – enterprise value divided by earnings before EBITDA
- P/E –market capitalisation or equity value divided by net income
- EV/sales – enterprise value divided by sales (used where companies do not generate any profit)
- Easy to calculate
- Data is usually widely available
- Trading comps should provide a reasonable valuation range
- Can be influenced by temporary market conditions rather than fundamentals
- It is not useful when there are few or no comparable companies
- It is not useful if comps are thinly traded