Chapter 10: Valuation

After understanding the three-statement model and ratio analysis in Chapter 9, Ratio Analysis, we can now proceed with the valuation of the company using the absolute method (Discounted Cash Flow (DCF)) and the relative method (comparatives).

Whatever the reason for establishing and running a company, you will at some stage want to know the value of the business. This could be to identify weaknesses, determine whether the business is growing, stagnant, or deteriorating, apply for a loan, attract investors, establish a reference point as a platform for driving future growth, or prepare for divesting from the company. There are several methods of valuation, but the three main methods will be discussed in this chapter.

By the end of the chapter, you will know the differences between the two valuation methods. You will understand the elements that make up the DCF method of valuation and how they are calculated.

The following topics are covered in this chapter...

Understanding absolute valuation

It is widely accepted that the most accurate way to value an enterprise is by absolute valuation using the DCF method. Crucially, this method considers the time value of money. It also considers results throughout the life of the enterprise. This is the closest to the definition that an enterprise is worth the total cash flow it can generate.

The DCF method includes technical concepts and calculations. We will attempt to simplify those concepts; nevertheless, you will not have to repeat the complex computations required to derive some of the more complex formulas necessary for the valuation. They are readily discoverable in textbooks and over the internet.

The DCF method continues from where the three-statement method ends. It begins with the concept of free cash flow. The goal is to determine the cash flows generated by the company. However, you need to recognize that some of the cash generated is committed, inter alia, to satisfying the debt...

Understanding relative valuation – comparative company analysis

Relative valuation relies on the theory that, in general, similar companies will produce similar results. This may be a bit simplistic, but in a discipline that involves a lot of assumptions and estimates, relative valuation is popular among analysts as it provides a plausible way to arrive at the value of a business that is quick and simple. The actual calculations are straightforward. The difficulty is in identifying comparable companies. The main criteria to consider are as follows:

• Industry – With reference to your major source of income, identify the appropriate industry to which the company belongs and look for examples within that industry class.
• Size – The relationship between size and profits is not exactly linear. A company with twice the asset base will not necessarily make twice as much profit. There may be economies of scale and access to restricted benefits as a result of...

Interpreting the results

A summary of the results is shown in the following figure:

Figure 10.11 – Summary of valuation results

These results can be displayed in graphical form in what is referred to as a "football field." It gets its name from the way the different valuations are scattered around the chart like football players. To do this, we start by expanding our previous table, as follows:

Figure 10.12 – Data for chart

Highlight the table and select Insert | 2-D Bar | Stacked Bar. The following figure shows how to select the chart from the ribbon:

Figure 10.13 – Selecting 2D stacked bar chart

A 2D stacked bar chart is created from the information in the table selected, as shown in the following figure:

Figure 10.14 – 2D stacked bar chart

We will need to make a number of formatting changes to the chart:

1. First of all, we will select Switch...

Summary

This chapter included a lot of new and varied concepts, and you are encouraged to review it more than once. It is a very important chapter as it represents the final step before we present our recommendations to the decision-maker.

In this chapter, we have looked at absolute and relative methods of valuing a company. We have explained the time value of money and the different formulas used in calculating the EV and share price of a company. We have understood the concepts of free cash flow, WACC, and terminal value. We have also seen how to represent our results in a chart, which can be used as a simple visual aid for decision making.

In the next chapter, we will look at why it is necessary to test your model and how to apply a number of tools to test your model.