what's up everyone kenji here and in this video i thought i'd share the three main methods to
value a company so firstly we'll look at the multiples based approach which is also known
as the market-based approach secondly we'll look at the discounted cash flow also known as the dcf
and then thirdly we look at the cost approach which is probably the least common of the three
after that we look at the pros and cons of each because unfortunately
none of them are actually perfect and then lastly we'll go over how to look at them all together
with something that's known as the football field which is a chart that looks like this one here
but before we get into it why on earth would you want to value a company well from a business
point of view you might want to value company maybe because you're looking to acquire it
or vice versa maybe you're looking to sell your own company or sell a department of your company
and you want to know how much that's worth right so that's one reason you might want to value a
company the second more individual reason might be because say i'm looking to buy apple shares
and i want to know if i'm buying them at a good price if they're a bit too expensive or they're
undervalued then i could make some money on that right so that's another reason why you
might want to value a company and while i'm talking about valuing companies here the same
three valuation methods also apply to valuing other things like what might be a piece of real
estate what might be say a piece of software or even a department within a company right so
they're really widespread you can use them across all sorts of assets so let's get into them the
first approach we'll be looking at is a multiples based approach which is also known as market based
and if you don't know what a multiple is it's basically a ratio right so it's one number over
the other a typical multiple for instance could be the p e ratio price per share divided by earnings
per share and in short it's about comparing what your company's worth relative to other similar
companies in the market right when you think about it it's actually not that different to you say
buying an apartment and seeing the price of the apartment relative to other apartments in the area
with the ratio or the multiple being the price per square foot or the price per square meter right
and some of the more common multiples in finance at least could be enterprise value over sales it
could be price to earnings like i mentioned earlier enter enterprise value over ebitda
which stands for earnings before interest tax depreciation and amortization i know it sounds a
bit daunting but in short it's just another way to measure profitability so let's look at an example
and let's say that we're trying to value company x using the pe multiple and like i mentioned
earlier the p stands for the price per share whilst the e stands for the earnings per share
and here basically you're going to want to look for companies firstly that are
similar to yours right let's say company x is a tech company so you look in the market for other
companies in the same industry in this case in tech let's say company x is primarily in europe
so you want to look for similar companies that are primarily in europe as well and also you want to
look at companies that are of similar sizes right you can't really compare a company that has 1
million in revenue to one that has one billion in revenue right and let's say that after doing some
market research we come up with five different companies and not very creatively i've named
them a b c d and e and so now we want to find the relevant data to compare them right so in this
case we gotta find the price per share as well as the earnings per share for each of these companies
so once we have that information noted we're now gonna be able to find the actual pe ratio for each
of these five companies and with that we're then gonna take the average pe ratio for all the five
in this case it's 7.9 and like i mentioned earlier we want a value company x and let's say that we
know that company x has an earnings of three dollars so based on that you're gonna be able
to do the three times the 7.9 and that's going to give you the share price in this case that's 23.55
and i do want to point out that this example is very simplified there's still a lot of flaws
in it so for instance the pe ratio depends on earnings right the e down there means the earnings
but what if the company doesn't have any earnings maybe they didn't make a profit last year then how
can you do a p ratio and the answer is that you can the p ratio is not applicable in this case
so you would have to use some other ratios as well that's why i mentioned earlier the enterprise
value over sales for instance also in this case we use the average rate but sometimes the average
isn't all that good and that's mainly because it accounts for outliers right so if one of the
say five companies we picked has a very very high p ratio that means it's gonna bring the
average absurdly high as well right instead you might want to use a median typically
for finance professionals they use both the average and the median as well
just in case there's any outliers where the median obviously doesn't account for them and i could go
on with many of the other simplifications that i had to make but i don't want to make this video
too long but if you'd like me to do a video just specifically on the multiples based approach do
let me know in the comments if this one does well make sure you hit that like and that subscribe
i will try to do a part two or something like that where i'll just cover this specific
valuation method now the second approach is known as the dcf the discounted cash flow
and this one's based on intrinsic valuation and you're probably wondering just like i did back in
the day well what the hell's intrinsic mean and basically it just means that it focuses
internally so inherently within the company as opposed to looking at external factors
when we looked at the multiples based approach it focused on other companies right whilst when you
look at the dcf intrinsically that means that it's focusing internally on the company's operation on
its business on its cash flows and basically a dcf is about finding the value of the company today
based on future projections of how much money it's going to make in the future and let's look
at a simple example here let's say that based on past cash flow growth rates we think that company
x will be able to have stable cash flows of 10 million up until year five okay so we have these
cash flows for the next five years does that mean that we just add up those five years and that's
going to give us a valuation and the answer is unfortunately no and that's because of this thing
called the time value of money which you might be familiar with if you've taken some finance
classes and it basically says that a dollar today is worth more than a dollar dollar in the future
that's mainly because of things like inflation rate which is actually eroding the value of your
money over time so instead we need to discount all these cash flows back to the present right
hence why it's called a discounted cash flow after all and we'll do that using a discount rate so the
formula is going to look something like this and it looks a bit daunting but to be honest it's
really not that hard the cf up here is the cash flow whilst on the bottom you have the r which
stands for the discount rate and those numbers there you see as well as the m stand for the
number of periods in this case for us it's years right and let's say that the discount rate we want
to use is five percent and so for year one that would be ten million over one plus five percent
in year two that would be eleven million divided by one plus five percent squared because it's year
two and then year 3 would be cubed and so on and so forth right and once you discount all of them
back to the present and sum them all together that's how you will get evaluation in this case
it would be 23.29 million now unfortunately i need to break some bad news and that's that it's quite
simplified as a model right what about after those five years does the company just suddenly stop
functioning probably not right there's probably gonna be some business beyond those five years
that's basically calculated using what's called the terminal value which is essentially the value
of the business after those five years and this is a big assumption right you're saying that
after this five year period for the remaining life of the company which you don't even know
how long it's gonna live for you're gonna value it at x amount and there's really two main ways
to calculate the terminal value the first one is known as the perpetual growth method and
the second one is known as the x and multiple method now i'm not going to get into them in
this video just because i don't want it to get too long but i will leave a very good article
which is actually how i learned this back in the day in the description as well also another
simplification that i wanted to point out here is the discount rate in this case we said it was 5.5
i honestly made that number up it could have been any other number but in reality there's actually a
way to calculate this and that's using the walk which stands for the weighted average cost of
capital now it's this massive formula um it looks a bit daunting but to be honest it's a lot simpler
than it looks and i'll leave an article on this formula in case you want to understand it and
look further into it i don't really want to get into it in this video but like i said earlier if
you want me to do a full in-depth on dcf as well do let me know in the comments if this video does
well i will consider it of course so the third valuation approach i'm gonna be covering is
known as the cost approach it's also sometimes called the replacement cost approach basically
this one's very common in real estate not so much in corporate finance roles like what might be
say investment banking or private equity in short it says that the value of the business should be
the cost to replace it with an equivalent new one right so for example if your business just
burned down say your factory burned down one day what would be the cost to create a new one just
like that right that's basically how they would measure it and overall what it's saying is that if
it would cost you say 10 million to replace that then you don't want to pay anything more than 10
million for the array so let's look at the formula for this and let's say that we're valuing a house
so the formula would be the replacement cost which is basically the cost of the construction
the architect and so on minus depreciation which is basically the wear down of the house over time
right which is actually making it less valuable and then lastly you want to add the value of the
land that it sits on now this approach works best for tangible things which are basically things
that you can touch right think say a manufacturing plant a house or a cell tower for instance that's
primarily because you know the cost of each thing quite well well on the other hand for something
like say an intangible or something that you can't touch like what might be a software a specific
algorithm you can't really replicate the cost in the same way because maybe you just had one genius
founder that managed to make this algorithm that no one else can in that case it's not like you can
pay somebody else to try doing right so the costs there are a bit blurred hence why it's a lot more
common in real estate for instance now let's look at the pros and cons of each method and starting
off with the multiples approach here among the big pros is that it's quite intuitive right it's
easy to understand it's quite relatively easy to do and so that's one of the main pros about it
now on the coin side it's really not that easy to find the similar companies to the one you're
trying to value right let's say i'm trying to value amazon for instance there's really not
that many companies that are all that similar of the same size same geography same e-commerce
market and so on and so forth right like let's say we want to compare to walmart for instance another
big retailer but walmart's not so focused on the e-commerce space it's more on physical stores
and so it's not that easy to actually find good comparing companies now moving on to the dcf and
the main pro here is that it's independent of the market right like i mentioned earlier it's about
the intrinsic value so whatever the competitors are doing doesn't really matter and that's
particularly good say for instance if you're in a recession most of your competitors are going to be
really down right so if you use a multiple space valuation odds are your company is going to be
very down as well right well for instance if you use a dcf that's going to be independent of how
the market's doing and instead you really have a core view of whatever your business is looking
like one of the big cons in the dcf is that it's hard to do right it's very time consuming so if
you've ever been asked in an interview to do a evaluation on a company and you have the choice
of doing a multiples approach versus a dcf you always want to pick the multiples approach just
because it's going to make your life a lot easier right another big con here are the assumptions and
it's heavily assumption-based right and so that means that you might be a bit too optimistic on
your company you might be a bit too pessimistic on it and based on that you're going to have a flawed
valuation right typically i will say though that for a dcf say in a professional setting
there's usually going to have a lot of different case scenarios so for instance you'll have a base
case which is what you normally expect the company to do you'll also have a best case so a very
optimistic scenario say you think like it's going to grow a lot more you're going to expand into new
countries and so on and so forth and then you'll have a worst case scenario like say i don't know
you get sued a couple times and so on and so forth so based on those three you'll actually derive
three different valuations and based on how you're feeling you're gonna go with one or the other
lastly looking at the cost approach and the main pro here is that it's very easy to do right it's
quite easy to understand but on the coin side the costs are actually not that easy to account
for right maybe it cost you say um a hundred thousand to construct the house uh five years
ago but now the market's been booming and so it's a lot more expensive to construct the house now
things like that that maybe they're not that clear as you might expect right another con of the cost
approach has to do with government permits right and specifically with regulation so for instance
maybe you had a warehouse and that's been there for 20 years but now the new regulation says that
you can't actually build anything in that area so now you can't really have a replacement cost
anymore right because you can't build anything so that's where the model kind of might get flowed
and as you've seen in this pros and cons analysis none of the three methods are actually perfect
right they all have some flaws somewhere and that's why evaluation is mainly regarded as both
an art and a science and this brings us nicely to the last point which is the football field
valuation and like i mentioned earlier because none of the three methods are actually perfect
what they do is they actually bundle them together in a graph looking like this so that you can kind
of get a range based on that so it's called a football field because that's what it resembles
right i do think it requires a bit of imagination but well i think the names there to stay
also you can see that there's actually a 52-week high and low range as well and that's quite common
to have in there which is basically the share price how it fluctuated throughout the 52 weeks
so the the last year right so looking at apple for instance here you can find it's 52 week
high and low range too overall though when it comes to valuation the analyst isn't actually
looking for a specific number instead they're looking to derive a valuation range right and
let me know in the comments if you'd like me to do a three-part series where i cover
each of the three evaluation methods make it maybe i could make it excel based where i actually do a
full case study of say apple or a big company like that and we try to value it together
so that's all for this video i hope you found it useful and i'll catch you in the next one
you