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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.

For more details on how to use the Discounted Cash Flow (DCF) method, have a look at our Net Present Value (NPV) lesson

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.

Take aways

  • 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.
7 Comment(s)
June 20, 2018 03:06 am -
Stefan

Explanation DCF:

DCF seems really uncommon. What you'd need is at least last business years cashflow and a growth rate for cashflows, or best the cashflows for the next 4-6 years (estimates given) and then you'll need rE, Cost of Equity.

Then you discount the cashflows given (or calculated with the growthrate) by the (1+rE)^t (rE is the cost of Equity. Should be given!). So for Year 1, its CF1/(1+rE) and for Year 5 it's CF5/((1+rE)^5). Then you need the terminal value of the company: Latest Cashflow*(1+g)/(rE-g). This you'll divide again as follows: TV/((1+rE)^t) (t here would be just one period more). Add everything up and you have the Equity Value. Divide it by number of shares and you have a shareprice. Add Net Debt to the Equity Value and you have the Enterprise Value.

Explanation Multiple:

First: Ask for an EBITDA multiple or the most common multiple that would be used. Don't buy the assumption that EBITDA*10 is good. It differs widely from industry to industry and right now as companies are valued high, the multiple rises as well.

How is it done? Most commonly you will use EV/EBITDA (EV = Enterprise Value). EV is Net Debt + Equity Value (aka shares). This method is great for valuating Private Companies, as you have no shareprice. So if you have the EBITDA-multiple of the industry, lets say 15, you'll go and calculate the EBITDA of your private company. Then you multiply EBITDA by 15 to get the estimate of the EV. Substract Net Debt to get to the implied Equity Value.

As you can see, it's really easy. Btw: Why EBITDA and not EBIT or Sales? Sales is a bad way to compare, because you don't use the cost structure. What good are sales, if your margin is bad? Why not EBIT? In this case you ignore D&A. This, however, has little impact on the company and to make both companies more comparable, you should not consider D&A. I think, this also shows why you wouldn't take Net Income as a multiple. There, capital structure is important: If you compare a highly levered (high debt) company with one that has no debt but cash, you'll have interest gains or costs impacting your Net Income. This, however, doesn't tell you anything about the operational value of the company. So, try to stick with EBITDA or the multiple given to you by the interviewer.

November 14, 2017 04:24 pm -
Sarah

An example of how to calculate it would be really helpful here. Not only for the DCF but also for the industry multiple method, please.

February 23, 2015 05:11 pm -
Philipp

As somebody with no knowledge of corporate finance, the DCF section did not really help me understand how to evaluate a company.
This was quite helpful as it explains how to use this method with an example. In general, an example (i.e. showing how some of these methods work and how we use them in practice) would be helpful.
http://en.wikipedia.org/wiki/Valuation_using_discounted_cash_flows

December 18, 2014 02:19 am -
ritika

Hi Eido,

Thanks for your feedback. Can you let us know which part you did not understand and what kind of examples are you envisioning? The section seeks to explain when and how "valuation" or "determining price of a company" is done. It also mentions that you likely would not need to do the calculations during the case interview but knowing that these methods exist would help. Let us know which part you would want more elaboration and we will try our best to incorporate your request.

Thanks again

December 16, 2014 06:50 pm -
Eido

In my opinion, this lesson is not explaintory enough and hard to understand. I beleive a few examples would clear things up.

October 07, 2014 10:20 am -
ritika

Daniel, Thank you for pointing this out. We have made the change to word it more precisely.

October 01, 2014 10:06 am -
Daniel

"Finally, you multiply the industry multiple with the CASH FLOW". Perhaps i have misunderstood, but shouldn't you multiply the industry multiple with the value of the firms assets?

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