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2. The Different Methods of Valuing a Company
Companies can be valued many different ways. In this lesson I'll explain two of the most common methods: income-based valuation and market-based valuation.
The 3 Most Common Methods of Valuing a Business
- Income-based valuation: forward-looking
- Market-based valuation: sideways-looking
- Cost-based valuation: backward-looking (not a focus for this course)
1. Income-Based Valuation
- Value is a function of the expected future cashflows of an asset
- Requires a lot of assumptions about the future
- More suited to assets with low uncertainty and stable cashflows
2. Market-Based Valuation
- Value is a function of the selling price of a similar asset
- Uses a comparable ratio between similar assets to determine valuation
- Easier to calculate than income-based valuation
- However, this method is very prone to cycles
How Cycles Affect Valuation
- In the expansion phase of a cycle, market multiples tend to rise
- In the contraction and trough phases of a cycle, market multiples tend to fall
- Good investors understand the importance of cycles when building valuation models
While there are many different ways to value a company, in this course I am going to focus on a couple of the most popular. Starting with income-based valuation, which is forward-looking and then moving on to market-based valuation, which is sideways-looking. In a previous course, I also mentioned cost-based valuation. But unless the business is in dire straits, we rarely use cost-based valuation and so I have excluded it from this course. For income-based valuation, value is set as a function of expected future cashflows of an asset. And that asset, can be a company. As you may have guessed, we use our financial projections to calculate these future expected cashflows. As we have seen in previous courses, financial projections rely on a lot of future assumptions. And so as a result, the more predictable the business, the easier it is to value using income-based valuation. Income-based valuation is normally calculated using what's called the Discounted Cashflow Method or DCF. All future cashflows from the business are calculated and then discounted back to today's value at a suitable discount rate. The sum of these discounted cashflows is the value of the business. Discounted cashflow calculations can take quite a bit of time, but thankfully, given that we have already calculated the financial projections for the company, we have the vast majority of the work completed already from MarkerCo. In contrast to the income-based valuation method, market-based valuation is relatively straight-forward. For market-based valuation, value is simply a function of the selling price of a similar asset. The simplest example are two houses. Say that the first house, a 4-bedroomed suburban house outside a large city has 3,000 square feet and the asking price is $450,000. The comparing metric in this case, to set the market-based valuation is $150 per square foot. Next door, we have a very similar house, again 4 bedrooms, but this time the floor space is 3,250 square feet and the asking price is slightly higher, $460,000, with a comparing metric of $141 per square foot. Let's now assume that the first house sells at $450,000. Setting the comparing metric at $150 per square foot on the market. Using market-based valuation, the second house should now apply this comparing metric to its valuation and arrive at an increased price of $487,500.
In this example, we use a comparing metric of dollars per square feet. But this can change depending on the asset in question. For example, if we want to take into account property, we might look at price divided by annual rent. If we want to take into account a company's stock price, we might take into account price divided by earnings. And if we want to take into account a startup, who may not have any earnings, we might look at a metric such as price divided by signed up user. For early investors in Snapchat, for example, this may have been the metric. Market-based multiples are very easy to calculate because they do not require a lot of assumptions or require you to build a pro forma set of financial statements. However, they are not forward-looking and they are very prone to market economics cycles. What may you ask, are economic cycles? Well a cycle is defined as a period of growth and decline in the market sector or industry. An economic cycle affects the whole economy, not just a specific sector, and it is 4 stages: expansion, peak, contraction, and trough. During the expansion phase, the economy tends to experience rapid growth. From a valuation perspective, multiples tend to be high during this phase. As investors expect future growth and revenue and earnings. Once the economy hits a peak and begins to contract, multiples lower as investors outlook becomes more bearish. Once the economy hits a trough phase, this cycle begins again. When valuing a business, it's crucial to understand what phase of the economic cycle or market cycle the business is in. If you time this incorrectly, the chances of you overpaying for a business or not spotting an undervalued business is very high. Particularly, when using market-based multiples. A typical economic cycle lasts about 5.5 years. But there is a wide variation in cycle length. From just 18 months to 10 years. A market cycle in a specific industry can last much longer and the affected, by circumstances, specific to that particular market. Again, when applying valuation to a business, it's important to understand the historic market cycles that the business has experienced. In the next lesson, we're going to explore some different definitions of value in a company. Namely equity value and enterprise value.