Question

What are the different ways that you can value a company and which is most appropriate for a energy sector

Answer 1

The different ways in which you can value a company are – DCF (discounted cash flow) analysis, comparable company analysis and precedent transaction analysis. In the DCF analysis a company is valued by discounting its future cash flows with its cost of capital. Comparable company analysis entails looking at trading multiples of the peers of the company that is being evaluated. Multiples like P/E ratio, EV/Sales, EV/EBITDA etc. are used. Precedent transaction is a type of relative valuation in which the company being evaluated is compared to other companies that have been sold recently or have been acquired recently. Using the average and median values of the multiples in recent sale and merger deals we can determine the value of the concerned company.

The most appropriate method to value a company in the energy sector is the DCF method. This is because we can optimally forecast the cash flow of a company in the energy sector and even determine the values of other variables that are used in DCF analysis. For instance we can run simulations for computing WACC (weighted average cost of capital). Data with regards to market risk premium, levered equity beta, risk free rate can all be computed easily and so cost of equity is determined easily. Cost of debt can be computed using a reference rate (risk free rate) and then adding a spread to it to reflect the risk premium. Operating cash flows and free cash flows can be forecasted after studying in detail the business of the energy company and the different factors that affects the company’s free cash flow and operating cash flow. As capital expenses tend to be consistent for energy companies DCF method suits well and works well when valuing these companies.

The DCF method can be used to value companies present in the energy sector like electricity, oil and gas, renewables, transmission system operator and even multi-utility companies.