Question

Briefly discuss the pros and the cons of the three (3) approaches used by analysts to value a company’s equity, namely, the free-cash-flow-based approaches, earnings-based approaches, and market-based approaches. Please provide numerical examples.

Answer 1

Free Cash Flow

The FCF methodology is based on the premise of the income approach: that the value of a company is derived from the future cash flows expected to be produced by that company. As its name suggests, the DCF methodology discounts these forecasted future cash flows to present value using a discount rate that takes into account the riskiness of a company’s estimated cash flows – in other words, the likelihood the cash flows will become real. From here, the Terminal Value is then calculated, which is the estimated present value of all of the cash flows (in perpetuity) beyond the forecast period. In all instances, free cash flows are calculated by deducting tax, cash required for working capital and capital expenditure from operational cash flow.

Pros:

• It’s the most theoretically robust method of a business valuation (at EquityMaven, we use it as our primary valuation methodology).
• The major positive of the income approach is that it utilizes in the valuation calculation the benefit streams produced by an enterprise. Since a business’s value is commonly considered to be the present value of its future earnings or cash flows, these methods emphasize the elements that are generally valued by the investor in a business

Cons:

• It assumes that the company being valued will survive and operate in perpetuity. But this assumption is not always correct, particularly for young and start-up companies
• The forecasting of future benefit streams and determination of a capitalization or discount rate often involve a high degree of professional judgment, which can subject the valuation to debate from other parties.

Market Based Approach

This is a market-based approach, and also the most commonly used approach to valuing a business. It looks at the prices which comparable public companies are trading at, relative to their earnings, in order to arrive at comparable valuation multiples. The most well-known multiple is the “Price/Earnings” or “P/E” multiple.

Typically for valuations of smaller private companies, the method uses an enterprise value relative to earnings before interest, tax, depreciation and amortization (or EBITDA) (“EV/EBITDA“) for comparable companies. These valuation multiples are then applied to the Sustainable EBITDA of the company being valued to derive a valuation. Sustainable EBITDA is used in the calculation to remove the effect of once-off or extraordinary items which are not expected to reoccur.

The difference between the DCF and EV/EBITDA valuations will most likely be attributable to differences in forecasted cash flow growth rates between the company being valued and the industry comparable companies used in the EV/EBITDA valuation.

Pros:

• Well understood by the public, and relatively easy to understand.
• More externally verifiable, as it relies on market multiples of comparable companies (or transactions) which have similar business activities and risks.

Cons:

• It can be extremely difficult to find truly comparable companies with similar growth prospects, in order to calculate comparable trading multiples.  
• As with the DCF methodology, it assumes that the company being valued will survive and operate in perpetuity. But this assumption is not always correct, particularly for young and start-up companies (although at EquityMaven, we adjust valuations for probability of survival)

Earnings Based Approach