7 Nov 2014

Types of Valuation

Standalone Valuation

As discussed above, there are two main types of valuation used to value a company, either an absolute valuation tool which attempts to arrive at a nominal valuation, or a relative valuation tool, which uses the value of other companies in the market to determine the value of the company being valued. The two types of tool and approaches have been neatly summarised by the following quotes by two successful investors:

An absolute valuation approach produces a nominal valuation, i.e. the value in pounds, dollars or euros that the company’s shares should trade at if fairly valued. This type of valuation is often called an “intrinsic value”, because it is highly unlikely that the company’s shares do trade at this value. An absolute valuation approach assumes that the market is inefficient at valuing companies. 

A relative valuation approach produces a valuation based on how other similar companies are valued by the market and assumes that the market, in aggregate, is correctly valued but that inefficiencies in valuation exist across the market or individual sectors. Both absolute and relative valuation tools are generally used to value a company on what is called a standalone basis, i.e. the company being valued is being valued in isolation.

Market Practice and Combination Valuation

In practice, a combination of absolute and relative valuation tools would be used to value a business. Often an absolute valuation tool such as DCF would be used as the first pass at valuation and then a cross-check would be performed using relative valuation tools such as multiples to gauge how the market was valuing similar companies. Other absolute valuation methodologies would be Economic Value Added (EVA) or Adjusted Present Value (APV).
In addition to valuing companies on a standalone basis, in practice valuation tools are often used that assume an element of corporate activity will take place. This can take the form of a comparable transaction (comptrans) valuation, where recent corporate transactions are used as a benchmark to determine the value of the company being valued. The assumption made is that because other companies have been acquired at certain valuation levels that these transaction values are relevant to the value of the company being valued. Corporate activity can also be incorporated by way of a combination valuation, where the target company’s value in a transaction will incorporate elements of value that would only arise as the result of a transaction, such as the synergy benefits from combining two companies.
Other specialised valuation tools include Leveraged BuyOut analysis (LBO) where a valuation based on the restructuring of a company’s capital structure in the form of a private equity, venture capital or Management BuyOut (MBO) transaction is carried out.

Key learning points:

  1. Standalone valuation approaches include absolute valuation and relative valuation. An absolute valuation approach assumes that the market is inefficient and a relative valuation approach assumes that, although the market in aggregate is efficient, inefficiencies exist across the market.
  2. Other forms of valuation include comparable transaction valuation, combination valuation and leveraged buyout valuation.

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