Even for a seasoned investment banking executive like Anil Chaturvedi, correctly valuing a company is no walk in the park. But the accurate valuation of companies is critical to an investment banker’s success. So, over the years, Anil Chaturvedi and the rest of the investment banking industry have devised several methods for valuing companies.
While it’s worth noting that valuation techniques may vary slightly based on the company being valued, there are several general valuation techniques used by investment bankers. In this article, by drawing on the experience and expertise of Anil Chaturvedi, we’ll review three of the most common valuation techniques used by investment bankers.
But if you are unsure what exactly investment banking is, maybe you should read through this Wall Street Prep guide before you continue.
Comparable company analysis
The concept of the comparable company analysis technique is fairly simple. Essentially, when an investment banker uses this technique, they’re analyzing a group of similar companies and drawing conclusions about company value based on a variety of financial ratios. For example, let’s say you want to know the value of Company A, which is a computer hardware manufacturer located in Illinois.
For an ideal comparable company analysis, you want to compile financial metrics for several other companies that manufacture computer hardware. However, these shouldn’t be just any computer hardware manufacturers. They should be as close as possible to Company A in size, structure, product mix, and area of operation. After all, if you’re comparing Company A, which is in Illinois, to a company in China, you won’t have a true “apples to apples” comparison. And without an apples to apples comparison, you’ll end up with skewed valuations.
After you’ve compiled a set of companies from which to compare Company A, you’ll generally look at one or more of the following valuation measures: price to earnings (P/E), price to sales (P/S), enterprise value to sales (EV/S), and/or price to book (P/B).
For example, if you knew that Company A was trading at 6 times the average P/E ratio, and the average earnings per share among comparable companies is $5.00, then Company A’s stock is worth $30 per share.
From this example you can see the importance of comparing similar companies. That’s because you can only draw conclusions relevant to Company A from Company B if those companies are very similar. For investment bankers like Anil Chaturvedi, the comparable company analysis is one of the quickest methods of analyzing a company. However, it is rarely the only method used because it’s most effectively used as a “ballpark” measure of value.
Precedent transaction analysis
The precedent transaction analysis valuation method, as the name implies, is a way to approximate the value of a company based on previous transactions. Of the three methods in this article, the precedent transaction analysis is the least exact. However, for those that are concerned with mergers and acquisitions, like Anil Chaturvedi, it does provide a general indication of the market’s demand for particular types of companies.
Again, the precedent transaction analysis relies on previous transactions, but not just any previous transactions. Just like how the comparable company analysis method relies on finding very similar companies from which to compare the company you’re valuing, the precedent transaction method requires analysts to find similar transactions. But unlike the comparable analysis method, finding the right transactions to analyze isn’t just about the similarities between companies.
Rather, for a meaningful analysis, investment bankers must find transactions that were similar in buyer type, structure, and timing. Even the method by which buyers raise funds to finance the purchase will play a role in the final price they pay. As such, analysts have to consider all the ins and outs of each transaction so they can arrive at the most meaningful comparison possible. Again, it’s important to remember that the precedent transaction analysis is most effective when it’s used to measure the market conditions for a potential company sale.
For example, even if Company B had an attractive valuation and they were hoping to be bought out, they’d likely still do some sort of precedent transaction analysis so they could understand the market conditions better. That way, they would know if they could expect some sort of transaction premium (a price above their valuation) or transaction discount. Depending on the business cycle, the regulatory environment, and thousands of other factors, two different companies with similar valuations could easily sell for far different prices.
Discounted cash flow analysis
So far, we’ve discussed the precedent transaction and comparable company analysis. Both of these methods of valuation give Anil Chaturvedi and his investment banking colleagues a “relative” value of a company. That is, the previous two valuations are based on the company in question’s “relationship” to other companies.
The discounted cash flow analysis is based on intrinsic value. In the discounted cash flow analysis, an analyst will evaluate a company’s projected cash flow then discount that cash flow based on that company’s weighted average cost of capital or WACC. This is an intrinsic measure because it is solely based on the amount and cost of capital for the company being analyzed.
A discounted cash flow (DCF) analysis is far more complicated than a precedent transaction or comparable company analysis, but most analysts agree that it is the most accurate method of valuation. Moreover, unlike the other types of analysis, the DCF analysis allows analysts to conduct projections based on a variety of scenarios. In this way, analysts can do a sensitivity analysis so the interested parties can understand a company’s valuation based on multiple possible outcomes.
Valuing companies is one of the most fundamental skills that investment bankers need, whether they’re a seasoned executive like Anil Chaturvedi or an entry-level analyst. For an entry-level position in the investment banking industry, you’ll undoubtedly need the ability to value companies in different ways.
Not only that, you need industry-specific knowledge because these methods of valuation still require critical thinking and strong financial knowledge to accurately value companies in a variety of industries during different times in the business cycle. And that’s part of what makes veterans like Anil Chaturvedi so valuable. It’s one thing to understand the numbers, but it’s an entirely different thing to understand those numbers in the context of the real world.