The bread and butter of a financial analyst is valuing a company. However, there are many different valuation methodologies, and many different ideas for what the value of a company is.
A logical place to start is what do we mean by ‘the value of a company’?
The obvious choice for determining the value of a company is the Stock Price, and the basic intuition behind this is that a company with a higher stock price should have a higher value. However, this is in no way correct. For example, let’s have a look at the following numbers.
Stock Price: $10
Outstanding Shares: 100
Stock Price: $1
Outstanding Shares: 10,000
When we are with this information, we can calculate what is called the ‘Market Value’ of the company. (More on this topic later.) In this case, Company A has a market value of $1000. Company B has a market value of $10,000. Therefore, we can see that even though Company A has a stock price that is 10% of Company B, Company B is worth 10x more.
The important takeaway here is this: stock price gives no indication as to the value of a company, but its movements tell us if the market is valuing the company upwards or downwards.
The calculation we undertook in the last section comes up with a number called the ‘Market Capitalisation’. This, theoretically, is what the market values the company at. While it is not usually enough to determine the true value of a company, it is a good indication as to the size of a company when doing Comps analysis.
Every Finance student will come across Enterprise Value during their education. Usually, that will be in the following form;
Enterprise Value (EV) = Market value of common stock + market value of preferred equity + market value of debt + minority interest – cash and investments
While this definition is great for determining the answer to an exam question, actually understanding enterprise value requires a little bit more thinking.
The Enterprise value is essentially the ‘takeover price’ of a company. The reason we use this instead of the market cap is because all of the firm’s debt would need to be paid off. However, the cash on the company’s books could be used to do this. Therefore, we can essentially write the Enterprise Value equation in a simpler fashion;
Enterprise Value (EV) = Market Cap + Debt – Cash
It is useful at this point to run through an example.
In this case we can see a company with a market cap of $100,000. If an acquirer were to buy all outstanding shares, they would pay $100,000. They would then be required to pay all of Fictional Company’s debt, increasing that price to $107,000. However, they would be able to use the $3,000 cash on the books to do that. Therefore, the final price of the transaction would be $104,000.
An important sidenote here is that you will often hear the term ‘Net Debt’ being thrown around. Net Debt is simply the total debt, net of any cash. In this case, Fictional Company’s net debt is $4,000. It is often a good idea to use the concept of net debt when analysing companies, as it can make the formulas in an excel spreadsheet simpler and easier to audit.
Clearly, enterprise value is a good number to shoot for when valuing a company. However, there is a very, very big elephant in the room. The efficient market hypothesis.
The Efficient Market Hypothesis
Academics will argue that the market will always value everything using all information available. Of course, in practice we know that this isn’t true. So that makes determining enterprise value a little bit more difficult. If the market has valued a company incorrectly, the market capitalisation number will be wrong. This is where we get to the section on valuing companies.
I will set out in this section saying that I am currently a Finance student, and I am still learning how to value companies. However, I do know the basics of how different methods work.
In general, there are two main ways of valuing a company, each with its pros and cons. They are; the Discounted Cash Flow and Comparable Analysis.
The Discounted Cash Flow (DCF) is arguably the more academic of the two. It requires making a forecast in perpetuity of the cash flows available to investors, discounting those cash flows back, and then arriving at a stock price. Once this stock price has been arrived at, you can determine market cap, and therefore enterprise value.
The DCF is a good way of valuing a company due to the fact that it does not require any market data, thereby removing the ‘mispricing’ of the market. However, it does require projections of the company’s future performance. The projections can be difficult to make, and the end result can be very sensitive to these projections. It is therefore advisable to create a ‘sensitivity analysis’ matrix in a DCF model to make it more useful.
The other option is the Comparable Analysis (Comps Analysis). This involves choosing a ‘peer group’ and using market derived multiples (usually using Enterprise Value) to compare the companies and find one that is mispriced. For example, using the EV/EBITDA multiple will show us how the market is valuing companies according to their earnings.
While a comps analysis is much simpler, it does not provide an intrinsic value for the company. All it does is tell us if a company is over or under valued by the market, in relation to its peer group. Of course, the selection of a suitable peer group is therefore paramount to a successful comps model.
The world of financial analysis is very big and very daunting. It can be difficult to know where to start. A good place is the Wall Street Prep YouTube channel, for a very basic explanation of some of these concepts. Beyond that, Wall Street Prep also has Self-Study Online Courses to teach you financial modelling and analysis. I highly recommend these is you are interested in learning these skills. While quite pricy, the Premium Package is very good starting point. It includes Financial Statement Modelling, DCF Modelling, Trading Comps, Transaction Comps, M&A Modelling and LBO Modelling. They can be found at www.wallstreetprep.com