Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

MARKET APPROACHES

In this section, I will discuss two market approaches: guideline multiples analysis and guideline transactions analysis. In both of these approaches, the term “guideline” is simply another way to say “comparable.”

Guideline Multiples

Multiples analysis is commonly used by investment analysts. It involves identifying publicly traded companies engaged in similar business activities and that have risk–return characteristics that are similar to those of the company being analyzed. The analyst then uses the prices at which shares of those publicly traded companies are trading to infer something about the company of interest, such as whether the company’s shares are over- or undervalued. Similarly, if an analyst is valuing a closely held business, guideline multiples analysis might help the analyst estimate the fair market value of its securities.

Commonly used multiples for assessing equity value are price/earnings, price/dividends, price/revenue, and market value/book value. Other ratios divide enterprise value by a proxy for cash flow, such as enterprise value/revenue or enterprise value/free cash flow.1 These enterprise multiples are used to derive a value estimate for the total business.

Applying the guideline multiples approach is conceptually straightforward, but in practice, applying the approach correctly can be very difficult. For instance, often a business has no true comparables, or what are often called “pure plays.” This can be very frustrating because ...