Valuation process contains several steps:
- Business summary: it covers macro and micro analysis, review of financial statements
- Pro-forma financial statements: includes forecasts that are inputs for valuation models
- Business valuation: converting collected data into valuation by using appropriate models
One of the steps of the part 1 is to understand an industry structure and Porter’s five forces can be helpful:
- Rivalry in the industry
- Threat of new entrants
- Threat of substitutes
- Power of suppliers
- Power of buyers
To forecast a future performance either top-down or bottom-up approach may be used. In the first case starting point is a macro and industry predictions that are followed by a company and individual asset projections. In the second case separate store budgets can be accumulated into a whole business forecast.
Valuation models can be divided into two broad – absolute and relative categories.
- Absolute valuation models
The most important type of absolute valuation models are present value (PV) or discounted cash flow (DCF) models:
- Dividend discount models
- Free cash flow to equity models
- Free cash flow to firm models
- Residual income models
Another category is asset based valuation that values a company on the basis of the market value of assets it controls. It can be appropriate for some particular industries or may formulate a bottom line for going concern entities.
- Relative valuation models
Main idea is that similar assets that are called comparables have to trade at similar prices. It is called the law of one price. The following ratios are the most familiar tools used for valuation:
- Price multiples
- Price to earnings (P/E)
- Price to sales (P/S)
- Price to cash flow (P/CF)
- Price to book value (P/BV)
- Enterprise value multiples
- Enterprise value to EBITDA (EV/EBITDA)
- Enterprise value to sales (EV/S)
During the valuation process several available approaches are used and the final result is a weighted average of used methods.