Introduction

Investment banking is all about valuing businesses or assets. A deep understanding of the proper valuation methodologies of valuing companies lies at the core of exercising logical decisions.

In order to do well in the interview process you need to understand the main valuation methodologies, how to implement them and the critical nuances that could influence the outcome of a each.

In investment banking interviews, valuation questions are inevitable. Interviewers expect you to understand various levels of valuation complexity:

• Basic: Understanding what valuation is and why it matters. For example, knowing the difference between intrinsic and relative valuation.

• ‍Intermediate: Explaining methodologies like Discounted Cash Flow (DCF) analysis or Trading Comparables, and why different scenarios might require different approaches.

• Advanced: Applying more complex valuation techniques like Sum-of-the-Parts (SOTP) analysis or Leveraged Buyout (LBO) valuation, and understanding the strategic implications of these methods.

What is Valuation

Valuation is the analytical process of determining the present or anticipated value of an asset, company, or investment. This involves various methodologies that consider factors such as management quality, capital structure, future earnings potential, and market conditions.

Relative Valuation

Relative Valuation determines the value of an asset by comparing it to similar assets. This method is popular due to its simplicity and relevance in comparing similar companies or investments.

Advantages:

• Ease of Comparison: Quickly compare investments within the same industry.

• ‍Market Relevance: Reflects current market conditions and investor sentiment.

Disadvantages:

• Ignores Absolute Returns: May lead to suboptimal investment decisions if market conditions are poor.

• ‍Short-term Focus: Can be influenced by temporary market fluctuations.

Intrinsic Valuation

Intrinsic Valuation estimates the true, inherent value of a company based on its fundamentals, often using complex financial models.

Advantages:

• Focus on Fundamentals: Provides a deeper understanding of a company's true value.

• ‍Long-term Perspective: Less influenced by short-term market volatility.

Disadvantages:‍

• Subjectivity: Heavily reliant on assumptions and projections, which can vary widely.

• ‍Complexity: Requires detailed financial analysis and modeling.

Key Valuation Methodologies

Market Capitalization

Market Cap assesses a company's value by multiplying its stock price by the total number of outstanding shares. This is a straightforward measure but only values the share of the business attributable to stock-holders as it does not account for debt or cash.

Discounted Cash Flow (DCF)

DCF estimates the present value of future cash flows using a discount rate. It is considered the gold standard for intrinsic valuation.

Advantages:

• Provides a detailed, long-term perspective.

• Can account for various scenarios through sensitivity analysis.

Disadvantages:

• Highly sensitive to assumptions about growth rates and discount rates.

• Requires reliable cash flow projections, which can be challenging for early-stage companies.

Expert Tip: Take advantages of our free resources. Check out the "DCF" post for a detailed overview of this topic.

Leveraged Buyout (LBO)

LBO valuation determines how much a private equity firm might pay for a company based on a target Internal Rate of Return (IRR).

Advantages:

• Sets a valuation "floor" based on financial leverage.

• Reflects practical investment decisions in private equity.

Disadvantages:

• Provides a conservative estimate, often lower than other methods.

• Relies heavily on the assumptions of debt structure and financial performance.

Expert Tip: Take advantages of our free resources. Check out the "LBO" post for a detailed overview of this topic.

Trading Comparables (Trading Comps)

Trading comps involve comparing a company's financial metrics with those of similar publicly traded companies to estimate its value. Although like-for-like comparisons are not always easy to attain, it is crucial to try to ensure as much as possible comparability among the group of peers you choose.

As you will often hear, you need to compare "apples to apples". In order to do that, you select comparable public companies based on the following criteria:

1. Industry: For example, Apparel, Food Groceries, Luxury Goods, Telecom.
2. Size: Based on a certain metric, typically Revenue or EBITDA, within a certain threshold e.g. looking at peers with EBITDA above £1Bn
3. Geography: US, Europe, Asia, etc.

Advantages:

• Reflects current market conditions.

• Easy to implement and understand.

Disadvantages:

• Difficult to find true comparables.

• Subject to market volatility and varying accounting practices.

Transaction Comparables (Transaction Comps)

Transaction comps look at past M&A deals in the same industry to gauge potential value.

Just like with trading comps, you also need to compare "apples to apples" when it comes to the transaction comps. Same as with trading comps, with one addition (time horizon):

1. Industry: For example, Apparel, Food Groceries, Luxury Goods, Telecom.
2. Size: Based on a certain metric, typically Revenue or EBITDA, within a certain threshold e.g. looking at peers with EBITDA above £1Bn
3. Geography: US, Europe, Asia, etc.
4. Time Horizon: Transactions from L1Y, or L5Y, for instance, depending on the availability of data.

‍Advantages:

• Based on real-world data and actual transaction prices.

• Includes control premiums paid in acquisitions.

Disadvantages:

• May not reflect current market conditions.

• Limited by the availability of truly comparable transactions.

Key Takeaway: Transaction comps typically leads to the highest valuation among all methodologies as it includes the control premium i.e., the additional amount a buyer is willing to / had to pay over the current market price to gain control of a company. This premium is usually ~30%, and reflects the strategic benefits and synergies that buyer expects to realize from the transaction.

Other Valuation Methodologies

Sum-of-the-Parts (SOTP)

SOTP valuation involves valuing each business segment of a conglomerate separately and then summing them up to get the total value.

Advantages:

• Provides a detailed breakdown of value by segment.

• Useful for valuing diversified companies.

Disadvantages:‍

• Requires detailed information about each segment.

• Complex and time-consuming to execute.

Dividend Discount Model (DDM)

DDM values stocks based on expected dividends, often used for financial institutions e.g., commercial banks.

Advantages:

• Focuses on cash returns to shareholders.

• Useful for companies with stable dividend payouts.

Disadvantages:

• Less applicable to companies that do not pay dividends.

• Sensitive to assumptions about future dividend growth rates.

Liquidation Value

Liquidation value estimates what would be left if a company were sold in parts, assuming all assets are sold and liabilities are paid off.

Advantages:

• Ignores market noise and focuses on tangible assets.

• Useful for distressed or bankrupt companies.

Disadvantages:

• Often produces very low values not suitable for healthy companies.

• Does not account for intangible assets or future growth potential.

Football Field Analysis

A football field chart visually compares valuation ranges from different methodologies, summarizing various estimates to provide a comprehensive view.

Key Takeaway: The football field provides a visual representation of valuation ranges that helps comparing different methodologies and assumptions.

Comparing the "Big Three" Valuation Methodologies

DCF: Detailed, fundamental analysis, but highly sensitive to assumptions.

Trading Comps: Reflects marked conditions, easy to use, but dependent on finding "true" comparables.

Transaction Comps: Based on real transactions, includes control premiums, but may not reflect current market conditions and there might be limited comparable data.

Conclusion

Valuation is both an art and a science, requiring a blend of quantitative analysis and qualitative judgement. By understanding and applying different valuation methodologies, you can gain a comprehensive view of a company's value and make informed investment decisions.