Introduction
Investment bankers are professionals who are well trained when it comes to managing assets, either through creation, transfer, or sale. One of the most important processes being undertaken by investment bankers includes valuation. When it comes to facilitating the operations related to the valuation models as well as assessment of business assets, they normally employ numerous skills and competencies. Business valuation methods represent the instruments that are applied in investment banking, so as to conduct the business value estimation so that the perspective investor could have the appropriate understanding of the current value of the business unit and the potential of the company as its current revenue. What makes valuation processes important in the field of investment banking is the fact that they enable businessmen (i.e. investment banking clients) to understand their current financial situation so that they can make the soundest of decisions (Rosenbaum & Pearl, 2013).
Whenever valuation procedures are conducted, the following factors are often taken into consideration: capital structure, earning prospects, the market value of the assets as well as the management style of the company. In this paper four popular business valuation methods will be discussed and they are: the discounted cash flow analysis, multiple methods, market evaluation, and the leveraged buyout analysis.
Discounted Cash Flow Analysis
The discounted cash flow (DCF) analysis is the most commonly used method of valuation. Focusing entirely on this specific method, the value of the asset refers to the present value of the company considering the net present and future (i.e. expected) cash flows of the assets being evaluated . The DCF analysis helps in the assessment and determination of the present value of an asset in a way that it enables the investors and the valuation procedures’ stakeholders to gauge their net position (finance-wise) over a specified time frame, a feature which would ultimately help them make sounder investment decisions . According to this valuation approach, every asset is important since it bears the current features of the company pertaining to the cash flows, risks it the financial market and the perspective growth of the business unit. Meanwhile, for the completion of the discounted cash flow valuation, the investor or other individual should have for the estimation the life (cycle) of the assets; cash flow analysis taking place during the life of the asset and the discount rate applying to the cash flows .
The most important figure to compute for when conducting a DCF analysis would be the net present value (NPV) of an asset. This is because the NPV is the variable that determines the positivity or negativity of the firm’s future cash flows. What makes this a good valuation method is the fact that it focuses on the internal profitability of the form so the effects of external factors that may affect the net present value of the business or asset may be minimized, leading to a lower level of valuation volatility. Moreover, the application of the discounted cash flow valuation allows the owner to understand the key essence of the business unit, its strengths and weaknesses, what provides the owner with the understanding where the company should be driven and which strategy to apply.
However, this valuation method has many disadvantages in contrast to other instruments. Given the fact that the discounted cash flow method aims to analyze the intrinsic value of an asset, this approach requires the evaluators to have access to high volumes of information information about the company in contrast with other valuation instruments. This method also leaves a sizeable room for possible manipulation of analysis outcomes since it relies heavily on valuation estimates (hence the term future cash flows) .
This method of valuation would be best applied in cases where the cash flows of the company can be considered valid, authenticated, and verifiable . On the bright side, this method allows the investor to make real-time changes in their decision—based on the profitability of the business, or any other outcomes .
How to come up with the DCF of a firm?
The process of estimating the value of an asset using the DCF approach can be divided into five steps:
Estimate the cash flow on a monthly or annual basis (depending on the timeframe)
Estimate the growth profile (measured in rates or %)
Make assumptions about the discount rate (i.e. interest rate prevailing)
Calculate the terminal value
Calculate the fair value of the company and any involved equity
Key Terms to Remember
Weighted Average Cost of Capital (WACC)
Often referred to as the cost of capital; dictated by the external market (e.g. prevailing interest rates) and not by the firm. This refers to the minimum amount of earnings a company must have in order to cover the cost of capital (if cost of capital is equals net earnings, then the firm being evaluated essentially yielded zero profits). This value includes all kinds of debts and liabilities. Formula for the WACC is WACC = E/V * Re + D/V * Rd * (1 – TC) where Re is the cost of equity, Rd the cost of debt, E the market value of the asset’s equity, D the market value of the asset’s debt, V is equals to E/D, and TC is the corporate tax rate .
Cost of Equity (Equity Cost)
This refers to the cost that the company needs to cover in order to satisfy the investors (i.e. shareholders) of a company; essentially a part of the WACC.
Tax Shields
Pertains to a certain reduction on income taxes for a corporation as a result of claiming allowable deductions on earnings in the form of other expenses such as mortgage interests, charitable donations, depending on the existing taxation law in the country where the firm is located.
Knowing all of these, there is no perfect form of capital structure. The important thing to always consider would be to come out with a net positive value after conducting a DCF analysis because that only means that the business being evaluated is earning. The terminal value, in most cases, should be evaluated in the target year where the investors are planning to liquidate or unload some of their investments in the business, or what is also known as the time when they are planning to reap their returns.
Multiple Analyses
There are numerous multiples (i.e. variables) that an investor or an investment banker may look at whenever he makes an investment decision and this is what multiple analysis is centered on . The multiple valuation method is composed of the following elements :
Selection of the value of the relevant and adequate measures;
Identification of the comparable firms and rivals of the industry;
Valuation of the peer group multiples;
Current application of the synthetic peer group multiple with the relevant leader of the particular industry
The advantage of the multiple valuation method lies in the fact that this analysis is simple in its application and usage. At the same time, this method requires less amount of time . Moreover, in contrast to the discounted cash flow method, this method involves less correspondence and documents . It also allows the person doing the analysis to focus on a specific industry or business class, making the results more concentrated and therefore appropriate to what they are trying to find out about an investment decision .
The presentation of the results of the analysis would also come in the form that is more understandable for the investors because what they would be looking at essentially would be comparable variables . What makes this analysis method popular in the field of accounting and finance is that it lets investors decide what variables or multiples they want to focus on improving .
There are numerous variables or multiples that a person using this valuation method may consider and they include but may not be limited to the following: Earnings per Share (EPS), Enterprise Value (EV), Sales (i.e. Revenues), and Price to Earnings Ratio (P/E).
The Earning per Share or EPS is obtained by simply dividing a firm’s net income by the outstanding number of shares that it has. This is a measure of how profitable a company is depending on its exposure and reliance to the investing public (measured in terms of float rating) P/E is obtained by dividing the price of the stock by the EPS. This is a measure of how expensive a stock of a company is relative to its earnings-backed valuation. EV is a little bit complicated because it is the sum of all the assets and liabilities (including debts and equities) of a firm. Revenues or Sales is the most simple because it simply measures how big the company earned (without considering the expenses yet). There is no perfect multiple or set of multiples (i.e. variables) that can be used in valuation. What matters is the goal of the person doing the analysis, on what he is trying to determine. Knowing when and where to use each tool is the real key to success in doing a valuation analysis.
Leveraged Buyout Analysis
The leveraged buyout analysis (LBO) is intended to help in the determination of the price that has to be paid by a financial buyer for a given target (i.e. a firm). This is an analysis that is usually helpful when it comes to the determination of the maximum price that has to be paid for an institution or company that is financing in the current debt markets, but would eventually generate a considerable return to a financial buyer.
How the LBO Method Works?
The LBO method becomes particularly important in cases where there is a looming merger or acquisition of a firm by a larger firm. In that case, the larger firm, assuming that it does not have the cash needed to purchase the firm being acquired, would issue a combination of debt and equity in order to finance the transaction. Ideally though, the transaction should be financed with cash because that means the company would not have to negatively affect its books just to make an acquisition. The next ideal situation would be an LBO that is composed of as little debt as possible (with a higher percentage of equity) because that would equate to a lower rating as far as leverage is concerned, although that would equate to a higher level of share dilution for the original shareholders (of the acquiring firm) because that would mean more shares would have to be issued in order to finance the buyout .
In most leveraged buyout arrangements, there are mechanisms that permit and facilitate a ratio of 10% equity to 90% debts. This ratio can change depending on the financial capability of the acquiring firm, the inherent value of the firm being acquired, among other internal and external factors that may affect the valuation analysis. In this example, however, there appears to be a high debt to equity ratio because the debt component is significantly larger. In most cases, this would make investors uncomfortable because this would mean that the company would exposing itself to credit risks (which is always a component of debt) just to finance the purchase or acquisition. History has proven that leveraged buyouts that have been facilitated based on these criteria often led to the creation of adverse effects on the acquired and acquiring companies; some even filed for bankruptcy later on because of not being able to service all of the resulting debt.
An example of an outstanding and high-level LBO on record is one where Kohlberg Kravis Robbers & Co. (KKR) among others managed to acquire HCA. Investment banks have always been carried out assets valuation as a mechanism that helps to determine the net worth of the companies to be acquired among other features that are of great concern to various stakeholders including the potential investors . A company’s success that is displayed by the balance sheet indicators can be used as the collateral to acquire loans in the banks and other financial institutions. Investment banks use them to assess the profitability and the profitability of the companies that are poised for acquisition.
Conclusions
There is more to valuation concepts, techniques, methods, and strategies, than the ones that were presented in this paper. The DCF, Multiples, and the LBO methods of valuation analysis, however, can definitely appear to be the most commonly used in the field of finance, accounting, and investment banking. It would only be safe to say that one of the most important steps to undertake whenever an individual or a firm has to make an important investment decision is to use a credible valuation tool or method (such as the ones reviewed in this paper) . To conclude, there is no perfect valuation tool or method. All of them have their own set of advantages and disadvantages. What matters the most is the skill to know when to use and not to use the available valuation tools and methods because that is what is going to determine the outcomes of the valuation process and all decisions that would be made (as a result of those valuation processes) thereafter. The above-mentioned methods for the valuation of the company's performance represent the most common instruments applicable to the business industry and investment banking. The author of this paper concludes, however, that the discounted cash flow analysis should be regarded as the most complicated for the analysts as it requires the significant amount of the information to be taken into account for the completion of the valuation, while the multiples method of valuation is the most popular for the market players. However, that is not to say that the DCF method of valuation is the most perfect or efficient one because again, each and every one of them is unique.
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