Investment banking is an incredibly lucrative career, with some first-year analysts earning up to £92,000 per year. The idea of earning that impressive amount as a 21-year-old inevitably draws a large number of students into the field. Unfortunately for us, this cultivates an extremely competitive environment. Crucial to becoming an investment banker is technical knowledge. Although not sufficient on its own, this article will summarise the three main valuation methods that are a must-know if you want to be successful in investment banking.
Let's start with something called comparable companies analysis. Colloquially referred to as 'trading comps', the premise for this valuation method is simple: the target company can be valued by ranking it against similar companies. This is because similar companies face similar risks, similar growth drivers, and similar financial characteristics. There are five key steps in the method of comparable companies analysis. The first step is to select a group of similar companies, which is called the 'universe of comparable companies'. Typically, these firms will have a similar financial and business profile to the target company, so for example, they would be a similar size in a similar sector. The second step is to locate the necessary financial information. It is handy if the company is publicly traded because of the quarterly reports, but not crucial. The third step is calculating lots of different ratios and statistics. There are far too many statistics to list here, but some of the key concepts being measured are size, profitability, return on investment, and a company's credit profile. These statistics are then used to calculate trading multiples, such as the price-to-earnings ratio. Once this is complete, the fourth step of benchmarking begins. This is where companies are all benchmarked against each other. From this, the final step of determining a valuation can be done. The multiples from similar companies are applied to the target company to give a range of valuations. This method's key benefit is that it is market-based, which means it reflects current market sentiment. However, this can also be a weakness if markets are skewed, so remember to consider the context.
The second valuation method is precedented transaction analysis. The premise (and method) for this is very similar to comparable companies analysis. It uses the idea that other companies' sale value can be used to indicate a value for the target company. The first step is to select a universe of comparable transactions. However, in addition to needing similar companies, precedented transaction analysis has the added difficulty that market conditions and deal dynamics also need to be considered. For example, a hostile takeover of a tech company in the dotcom bubble will be different from a friendly takeover of a tech company after it burst. The second step is to locate details of the transaction and calculate key stats and ratios, much like in comparable companies analysis.
Key statistics include equity value (offer price per share multiplied by the number of shares outstanding) and enterprise value (equity value + total debt + preferred stock + noncontrolling interest – cash and cash equivalents). The third step is to calculate the necessary trading multiples and benchmark them. Similar multiples are calculated as they were in similar companies analysis, for example, price-to-earnings ratio, although there are some additional ones for precedented transaction analysis, such as the premium paid multiple (offer price per share divided by unaffected share price all minus one). Once the multiples are benchmarked, the final step can be completed: valuation. The multiples can be applied to the target company to create a defensible range of values. This method is also an external method of valuation, which means it has the same potential benefits and risks as trading comps.
Finally, investment bankers can use the internal valuation method of discounted cash flow analysis (DCF). Here, the premise is that a company's value is equal to the present value of all its future cash flows. To make things a bit simpler, investment bankers break this process down into two components, free cash flow (FCF) and terminal value. FCF is how much cash is generated per year after all costs and taxes have been paid. This is calculated until the firm is in a 'steady-state'. Terminal value is essentially all the cash flow generated after the end of the FCF period. For example, if I were to calculate FCF for the next five years, the terminal value would be all the cash flow from the sixth year onwards. Luckily, because the firm is now in this 'steady-state', the terminal value is relatively easy to calculate. You can treat annual cash flow as a growing perpetuity and use the simple growing perpetuity formula. Once all of the future cash flows are projected, you have to discount them to get a present value. This is because £100 in 10 years is not worth the same as £100 now. The relevant discount rate is called the Weighted Average Cost of Capital (WACC), and as the name suggests, it is a calculation of how expensive financing is for that firm. To get the firm's final valuation, apply the discount rate to all the future cash flows and add them together.
Knowing these three valuation methods is a good start to improving your technical knowledge. The processes are a lot more complex than this, but if you understand the above, it is a helpful foundation that you can build on. To learn more detail, I would recommend the book called Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions.