How to Value a Company | Best Valuation Methods - YouTube

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