A Guide to the Different Types of Valuation Models
When determining the proper valuation method needed to estimate a firm’s value or security, it’s easy to experience choice paralysis due to the sheer number of possible valuation techniques at your disposal. Some models are relatively simple, while others are more complex; some work in certain situations while others are more appropriate when applied elsewhere.
Typically, it’s helpful to divide the most common valuation models into one of two categories, “absolute” and “relative.” Each has strengths and weaknesses and must be used situationally, particularly since every sector and industry has its own characteristics and challenges. Below, we’ll provide an overview of the primary investment valuation models for investment banking deal sourcing and discuss the best practices therein.
What are Valuation Models?
Estimating the market value of a company that is publicly-traded is quite straightforward: simply multiply the stock price listed on the exchange by the outstanding shares, and you have a solid number that represents the company’s actual value. When it comes to privately owned companies, however, determining their value isn’t quite so easy, which is why M&A software tools can come in handy. As CFA Institute writes:
When a private equity firm is performing valuations of potential acquisitions, this effort is particularly complex because in most cases, except for public-to-private transactions, there will be no market prices to refer to. Private equity firms can face considerable challenges in valuing these companies.
Since it’s rare for privately owned companies to publicly report their financial numbers and there’s no publicly traded stock to use as a windsock, a different approach becomes necessary. That’s where business valuation models come in. Simply put, such financial models are means by which both business owners and private equity firms can use to estimate—within a reasonable degree of certainty—the economic value of the business.
But why would this matter? For both business owners and private equity firms, there are several situations and reasons why valuation modeling would be indispensable, including:
- Business Owners
- They wish to add shareholders, therefore the value of the share needs to be figured.
- They intend to sell the business.
- To gauge their progress, performance, and success.
- They seek equity or debt financing in order to expand, but lack the cash flow.
- Private Equity
- To ensure they’re investing in a business that’s actually performing.
- To receive a fair market value for their equity investment.
- To provide credible and transparent estimates to stakeholders and ensure that safeguards are in place to protect them.
- To supplement the robustness of decision-making process.
A Guide to the Different Types of Valuation Models
Modeling for equity valuation can be tricky. It’s made all the more so due to the fact that markets and industries vary. Also, businesses aren’t static, some may be further in the growth phase than others. As Forbes notes:
Different types of investors focus on different stages of business. If you’re at the startup phase, pre-revenue—perhaps even pre-product—you may find a startup angel. In these cases, you can’t show a historical P&L, patented technology or equipment that has a logical or quantifiable value. At this stage, a company’s ‘potential valuation’ is based heavily on the vision of the founder, their assessment of a market need, the value of that market segment or category of offering, etc. These types of early, lead angels will assign a percentage of the entire venture they are willing to take in exchange for funding.
Due to the potentially drastic variance from one company to another, different types of valuation models become necessary. Even though they all have their own strengths and weaknesses, it’s helpful to group them into one of two categories.
Absolute Valuation Models
The first category that PE firms use to determine the value of a firm or security is known as absolute valuation models, which are:
The defining characteristic of an absolute valuation model is that in this model the value of the asset is derived only on the basis of characteristics of that asset. There is no consideration regarding the valuation of other comparable assets that are trading in the marketplace. These models are basically known as the “discounted cash flow” of the DCF models.
Absolute valuation models, also known as intrinsic value approaches, are the most commonly employed model and are based upon forecasting future cash flows and focus on fundamentals such as:
- Growth rate
- Cash flow
That said, they can be separated into a variety of subtypes, including:
- Discounted Cash Flow (DCF) Model – This model looks at the entire cash flow that the firm will accrue year-over-year. Once this figure is determined, you must subtract the money owed to third parties such as bondholders and the government. The remaining balance is the free cash flow to the firm. This is then projected over several years and then reasonably discounted to determine a suitable valuation number.
Per Investopedia: “The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow.” This lets you confirm a fair price value but necessitates that you weigh several factors such as profit margins and future sales growth.
- Discounted Dividend Model – This is applicable if the firm’s shareholders are restricted to dividend compensation. This method of valuation is based on the idea that the share price is considered to be a negative cash outflow, while dividends are a positive cash flow. The worth of the investment is weighed upon the expected future dividends in comparison to current market price.
According to the Corporate Financial Institute: the future dividends generated by the securities of any company provide a fair representation of the intrinsic value of that business, once discounted to their present value. The DDM assumes that the future cash flows of a company are equal to dividends that are generated on its shares and consequently distributed to stakeholders.
- Discounted Residual Income Model – This method of valuation employs an even broader view towards cash flow. One that considers all cash flow accrued to the firm once all third parties are paid. However, this doesn’t include payments to shareholders and bondholders.
Relative Valuation Models
Relative valuation models take a different approach to determining value and are commonly referred to as the market approach. They tend to compare the firm to similar firms in its market. Such methods require paralleling various calculations such as:
- Price-to-earnings multiples
Investopedia writes, “Relative valuation uses multiples, averages, ratios, and benchmarks to determine a firm’s value. A benchmark may be selected by finding an industry-wide average, and that average is then used to determine relative value. An absolute measure, on the other hand, makes no external reference to a benchmark or average.” So, although there are a few valuation financial models, the most popular are:
- Comparable Analysis – Sometimes referred to as equity comps or trading multiples, this relative valuation method compares the current value of the business to similarly sized and structured businesses based upon various ratios such as Enterprise Value/Sales, Enterprise Value/EBITDA, and P/E. This provides Private Equity firms with an observable value in contrast to analogous companies and helps them project future value.
- Precedent Transactions Analysis (PTA) – To determine the en bloc value of a business, particularly in light of M&A transactions, PTA compares the target business to similar businesses that have recently been acquired or sold. The transaction value will also encompass the take-over premium into the equation. Although PTAs aren’t as commonly employed as comparable analysis, they can be used strategically for more accurate metrics.
Seeking the Best Valuation
If your goal is to get the most accurate and fair valuation model possible, the best course would likely be to use a combination of both relative and absolute valuation methodologies. In truth, valuation is just as much an art as it is a science; therefore, it’s wise to find a valuation range and land somewhere in the middle of the high and low end. If you wish to produce the best valuation, it would be wise to consider using a powerful deal management software platform such as SourceScrub in order to attain as much firmographic data as possible.
The amplified sourcing data makes it simple to employ both relative and intrinsic valuation models. In addition, the Total Available Market (TAM) Analysis is optimized for searching and filtering functionality, allowing you to apply your own proprietary taxonomy of Industry keywords across a comprehensive record base. This comprehensive research process produces insights and data related to private businesses across industries, including investor information, growth data and other key financial firmographic points. Using these valuation methodologies, you can make the most informed decision possible when it comes to your PE investments.
- CFA Institute. Private Equity Valuation. https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/2020/private-equity-valuation
- Forbes. What’s Your Company Worth? The Art of Valuation. https://www.forbes.com/sites/moiravetter/2015/07/19/whats-your-company-worth-the-art-of-valuation/#231f25837b87
- MSG. Absolute Valuation Models Vs. Relative Valuation Models. https://www.managementstudyguide.com/absolute-valuation-models-vs-relative-valuation-models.htm
- Investopedia. Discounted Cash Flow. https://www.investopedia.com/terms/d/dcf.asp
- CFI. Absolute Valuation. https://corporatefinanceinstitute.com/resources/knowledge/valuation/absolute-valuation/