Valuation Methods

There are many different ways we can value a company, each with their own benefits and limitations. Which method should we use when valuing a start-up like Nio? Or a mature firm like Coca Cola? Different types of companies require different valuation methods, so this post will be a brief outline of the valuation methods of companies.

To start off, the basic and one of the most important concepts in finance is the time value of money (TVM). $1 today will, in general, be worth more next year, because of inflation. So moving forward in time, we compound the value of money, and moving backward, we discount it. Broadly speaking, the value of a company is the present value of the sum of all future earnings or cash flows of the company. 

1) Dividend Discount Model (DDM) looks at a firm's dividends. What we want to find out is, if the firm pays out a dividend each year forever, what would the sum of all those dividends be worth today? 

2) Discounted Cashflow Method (DCF) looks at a firm's cashflow. There are 2 types of cashflows we can use to estimate the value of the stock - either FCF to Equity (FCFE) or FCF to Firm (FCFF). 

3) Relative valuation method looks at comparing the firm to other firms in the industry. This method uses multiples to estimate the values, such as the Price/Earnings (P/E) ratio and EV/EBITDA.

4) Residual Income method. Residual income is the income that the firm has after deducting the costs from earnings.

There are definitely more ways to value a company, especially once we dive deeper into private equity (PE) or startups (VC space). From there, we will encounter more interesting valuation methods such as triangulation and metrics valuation. One example I've heard of is if you're trying to value a social media start-up, how would you go about it? You could possibly estimate the value per user of the industry and impose that onto the estimated number of users of the start-up to find the value. Modelling and valuation is an extremely versatile tool that one can use to estimate the worth of a company, we just need to know which to use and how to use it according to the type of business model the company has.