Valuation (finance) - Wikipedia

Investment Banking Valuation methods

Banking Investment / January 13, 2022

Investment banks perform two basic, critical functions for the global marketplace. First, investment banks act as intermediaries between those entities that demand capital (e.g. corporations) and those that supply it (e.g. investors). This is mainly facilitated through debt and equity offerings by companies. Second, investment banks advise corporations on mergers & acquisitions (M&A), restructurings, and other major corporate actions. The majority of investment banks perform these two functions, although there are boutique investment banks that specialize in only one of the two areas (usually advisory services for corporate actions like M&A).

In providing these services, an investment bank must determine the value of a company. How does an investment bank determine what a company is worth? In this guide you will find a detailed overview of the valuation techniques used by investment bankers to facilitate these services that they provide.

In this chapter we will cover two primary topic areas:

  • How do bankers determine how much a company is worth—in other words, what valuation techniques are typically used?
  • What are the advantages and disadvantages of each valuation technique, and when should which technique be used?

Valuation Techniques: Overview

While there are many different possible techniques to arrive at the value of a company—a lot of which are company, industry, or situation-specific—there is a relatively small subset of generally accepted valuation techniques that come into play quite frequently, in many different scenarios. We will describe these methods in greater detail later in this training course:

  • Comparable Company Analysis (Public Comps): Evaluating other, similar companies’ current valuation metrics, determined by market prices, and applying them to the company being valued.
  • Discounted Cash Flow Analysis (DCF): Valuing a company by projecting its future cash flows and then using the Net Present Value (NPV) method to value the firm.
  • Precedent Transaction Analysis (M&A Comps): Looking at historical prices for completed M&A transactions involving similar companies to get a range of valuation multiples. This analysis attempts to arrive at a “control premium” paid by an acquirer to have control of the business.
  • Leverage Buyout/“Ability to Pay” Analysis (LBO): Valuing a company by assuming the acquisition of the company via a leveraged buyout, which uses a significant amount of borrowed funds to fund the purchase, and assuming a required rate of return for the purchasing entity.

These valuation techniques are easily the most commonly used, other than in valuations for specific, niche industries such as oil & gas or metal mining (and even in those industries, the aforementioned valuation techniques frequently come into play). Different parts of the investment bank will use these core techniques for different needs in different circumstances. Frequently, however, more than one technique will be used in a given situation to provide different valuation estimates, with the concept being to triangulate a company’s value by looking at it from multiple angels.

For example, M&A bankers are typically most interested in Transaction and Comparables valuation for acquisition and divestiture. Equity Capital Markets (ECM) bankers underwrite company shares in the public equity markets in advance of an initial public offering (IPO) or secondary offering, and thus rely heavily on Comparables valuation. Financial sponsors and leveraged finance groups will almost always value a company based upon leveraged buyout (LBO) transaction assumptions, but will also look at others. Also, in many cases, all of these groups will employ some degree of DCF valuation analysis. These different divisions of an investment bank may come up with similar valuation ranges using some subset of the techniques given, but will approach this process often with entirely different goals in mind.

Thus all of these techniques are used routinely by investment banks, and for a banking analyst, at least some degree of familiarity with all of these techniques must be achieved in order for that analyst to be considered proficient at his or her job.

When To Use Each Valuation Technique

All of the valuation techniques listed earlier should be practiced by a junior banker, but some may be more applicable than others, given the group, the client, and the exact situation.

Comparable Company Analysis

The Comparable Company valuation technique is generally the easiest to perform. It requires that the comparable companies have publicly traded securities, so that the value of the comparable companies can be estimated properly. We will detail the calculation process for Comparable Company analysis later in this guide.

The analysis is best used when a minority (small, or non-controlling) stake in a company is being acquired or a new issuance of equity is being considered (this also does not cause a change in control). In these cases there is no control premium, i.e., there is no value accrued by a change in control, wherein a new entity ends up owning all (or at least the majority) of the voting interests in the business, which allows the owner to control the company cleanly. With no change of control occurring, Comparable Company analysis is usually the most relied-upon technique.

Discounted Cash Flow Analysis (DCF)

A DCF valuation attempts to get at the value of a company in the most direct manner possible: a company’s worth is equal to the current value of the cash it will generate in the future, and DCF is a framework for attempting to calculate exactly that. In this respect, DCF is the most theoretically correct of all of the valuation methods because it is the most precise.