Question

1. Discounted cash flow & Using market multiples of comparable companies are two major methods for business valuation. Please describe the process of how they are used to perform a valuation. (6 points) What are the problems with these methods despite its popularity? (4 points)

Answer 1

The method of discounted cash flow for valuation makes use of a company’s future cash flows for its valuation. The formula for valuation as per the DCF method is: DCF = cash flow in year 1/(1+r)^1 + cash flow in year 2/(1+r)^2 + cash flow in year 3/(1+r)^3+……. Cash flow in year n/(1+r)^n. In this formula r is the discount rate which is usually the WACC i.e. the weighted average cost of capita. Cash flow generally refers to the free cash flow.

Another method is the market multiples of comparable companies method. In this method we do the valuation of a company on a relative basis by comparing it to other companies operating in the same industry/same segments. This method makes use of trading multiples or equity comps or multiples. The multiples that are looked into are P/E, EV/EBITDA, EV/Sales etc. Using these multiples we can determine the current relative worth of a company.

The problem with DCF method is that estimating cash flows and estimating discount rates are not always easy. Cash flow projections for future are based on several assumptions and if an assumption is not proper it can throw off the cash flow projections. Estimating discount rates is also not easy as it entails computing WACC (weighted average cost of capital). Thus the method is prone to errors as well as to over complexity.

The problem with market multiples of comparable companies method is that it is a subjective method and the element of objectivity is not very high. Secondly direct comparable are not always present due to presence of scalar differences existing between most private enterprises and public operators.