Question

The Royal Hotel is being sold. The underwriter requests the pro forma statements showing future projected cash flows from the hotel owner. If the underwriter only uses this information, (a) which approach to valuation are they using? Please also (b) name and (c) briefly describe the other two approaches.

Answer 1

Different ways to Value a company

1. Discounted cash flow approach.
2. Market approach.
3. Asset or Cost approach.

By analyzing the pro forma statements showing projected cash flows, the underwriter is using the Discounted Cash Flow (DCF) approach to value The Royal Hotel. This is also called as an Intrinsic value approach wherein we forecast future cash flows and then discount them back to the current date using Weighted avg. cost of capital (WACC). To predict future cash flows, we have to make certain assumptions about how the company will grow, its capital expenditure, depreciation, etc.

Other most commonly used techniques are Market based and Cost based. In market-based valuation, we analyze the value of the company's competitors and compare their trading multiples like P/E, EV/EBITDA, etc with the target company's multiples and find its value. It is also called a relative valuation approach. It is a widely used approach as its easy to calculate and the logic is simple, that if a company X is trading at 5x P/E ratio, then a comparable company with earnings $3 will trade at price $15 (5*3). Another way to value a company is by looking at recent transactions of M&A (Precedent transactions analysis), and can find the value by comparing at what price the share of the target company was acquired.

The cost or an asset-based approach is basically to add the value of a company's tangible assets or the cost required to form another similar company. It is not used generally and is beneficial only when a company has a lot of tangible assets that can be sold.