There are many valuation approaches that one can use to value a company. Amongst the most common approach are:
1. Net asset approach
2. Market approach
3. Income approach
The net asset approach is often used in cases where there is no intangible asset or value such as brand name, reputation, experience, relationship with customers, and knowledge along with a variety of other values not captured in accounting numbers.
The net asset approach treats the business as a set of liabilities and assets where their net difference represents the net equity. Before applying the net asset approach the assets and liabilities needs to be set at their fair market values.
The market based approach determines the value of the business by comparing similar companies for which value is known. It compares the select company to the prices of similar companies operating in the same industry that are publically traded. These comparable values are EV/EBITDA and price multiples such as Price to Earnings, Price to Cash Flows, Price to Sales and Price to Book Value. These multiple are described in detail in the section of ratio analysis.
The income approach estimates the value of a company by considering income it generates over a period of time. This method is based on the fact that the value of a business is equal to the present worth of the future benefit of ownership. The most common approach to this method is the discounted cash flow.
This method discounts projected cash flows back to present value at a rate that reflects the risk inherent in projected flows. This rate is known as cost of capital which reflects the company’s financial structure and risk related to the sector.
There are two variants of discounted cash flow methods:
Free Cash Flow to Firm (FCFF)
FCFF values the entire business, which includes both the shareholders and all the other claim holders of the firm which are the lenders to the company. It is used for firms which have capital structure expected to change over time.
Free Cash Flow to Equity (FCFE)
FCFE values just the equity stake in the business. It applies to all equity shareholders of the company. It is used for firms which have stable capital structure.
Steps to estimate the value of a firm
DCF uses a two stage model, where the initial first stage the company is expected to experience high growth and later on grow at a steady rate usually at a rate where whole industry is growing or at a rate of economic growth.