Valuation cases usually require estimating the price of a firm, patent, or a service in the market
This type of case can either be a subset of an M&A case, in which you need to know a company's worth before purchasing or a standalone case (rare). For instance, “How much is Pfizer worth today?” In strategy consulting, these questions are rather rarely seen. However, cases where you do need to valuate something usually start with “How much would you pay for…”
The most common methods of valuating are the Discounted Cash Flow (DCF) and the industry multiple method
As these are still case studies meant to fit in an interview round, the interviewer will very likely not ask you to perform an exact and comprehensive valuation analysis. Instead, you may be required to estimate the worth of a product, patent or a service. You may also have to judge if an offered price is reasonable.
Discounted Cash Flow method
The first valuation method is the Discounted Cash Flow method. This method shows how much money you would have in your savings account at a certain interest rate in order to provide you with the same annual cash flow generated by the company that is being evaluated. Here, you simply divide projected annual cash flows by a discounted rate (or interest rate). Of course, the discount rate of your savings account will be much lower than that of an investment in a company. This is so because the risk you take putting your money in a savings account is much lower than the risk of investing in a company.
Industry multiple method
The DCF method is limited since it does not take into account additional dimensions other than money (unless you quantify those dimensions into the future cash flows).
Football teams, for instance, are often overvalued compared to their generated returns. For such cases, there is another method called the industry multiple method.
This method allows you to valuate a firm by using a metric known to this company and multiplying it by the associated industry multiple. This can be done for similar players in the industry to assess their relative valuations using a benchmarking.
An example of a multiple ratio is the price-to-book ratio (P/B). This multiple is the ratio of the actual firm valuation (based for example on M&A deals) and the book value of the same firm (value of its assets which can be found in the balance sheet). If a firm’s assets added up to 200 million and it was sold for 100 million, the ratio is 0.5 (100 million/200 million). Do this for a set of representative industry players, take the average and you get the average industry multiple. Finally, you multiply the industry multiple with the value of the assets.
Other commonly used ratios are the price-earnings ratio (P/E ratio or PER) and the EBITDA ratio.
Since you will not be required to calculate the value of an investment on too high a level of detail, it is not necessary to learn values for different interest rates or industry multiples by heart. However, to give you an idea about orders of magnitude:
- A good guess for an industry multiple is EBITDA*10.
- Good guesses for interest rates would range from 3% (inflation) to up to 20% for highly speculative investments.
- Use the Discounted Cash Flow (DCF) method to valuate a firm based solely on its expected profits.
- Use the industry multiple method to double check if the DCF valuation is reasonable. Sometimes other aspects need to be factored in like brand value, customer loyalty, liabilities etc.
- There are several types of industry multiples to choose from. For more precise valuation, choose more types of industry multiples.