Business Valuation Methods

Why This Matters

Business valuation sits at the intersection of finance, strategy, and tax planning—making it one of the most heavily tested areas in this course. You're being tested on your ability to select the right valuation method for a given scenario, understand how tax implications affect value calculations, and recognize when different methods will yield dramatically different results. The methods you'll learn here directly impact M&A decisions, tax basis calculations, estate planning, and corporate restructuring.

Don't just memorize formulas—know when each method applies and why it matters for tax strategy. Exam questions will push you to compare methods, identify which approach fits a specific business context, and explain how financing decisions and tax shields influence valuation. Master the underlying logic, and you'll recognize the right answer even when questions present unfamiliar scenarios.

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Intrinsic Value Methods

These methods calculate value based on a company's own fundamentals—its cash flows, earnings, or dividends—rather than external market comparisons. The core principle: a business is worth the present value of the economic benefits it will generate.

Discounted Cash Flow (DCF) Method

• Projects future free cash flows and discounts them to present value using the weighted average cost of capital (WACC)—the gold standard for intrinsic valuation
• Highly sensitive to assumptions—small changes in the discount rate or terminal growth rate can swing valuations by 20% or more
• Best for companies with predictable cash flows and when you need to model specific tax scenarios, capital expenditures, or changing growth rates

Earnings Capitalization Method

• Converts expected earnings into value by dividing by a capitalization rate—essentially a simplified, single-period version of DCF
• Capitalization rate reflects risk—higher risk businesses require higher rates, producing lower valuations
• Ideal for stable, mature businesses where earnings are consistent and detailed multi-year projections aren't necessary

Adjusted Present Value (APV) Method

• Separates unlevered firm value from financing effects—calculates base value first, then adds the present value of tax shields from debt
• Explicitly values tax benefits of debt as $PV(\text{Tax Shield}) = T_c \times D$ for permanent debt, where $T_c$ is the corporate tax rate
• Essential for leveraged buyouts and restructurings where capital structure changes significantly over time

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Dividend-Based Methods

These approaches value equity based on cash returned to shareholders through dividends. The underlying logic: shareholders ultimately care about the cash they'll receive, and dividends represent that direct return.

Dividend Discount Model (DDM)

• Values stock as the present value of all future dividends—expressed as $P_0 = \sum_{t=1}^{\infty} \frac{D_t}{(1+r)^t}$
• Requires stable dividend history—inappropriate for growth companies reinvesting earnings or firms with irregular payouts
• Tax implications matter—dividend tax rates affect after-tax returns to shareholders and can influence whether this model reflects true economic value

Gordon Growth Model

• Simplifies DDM with constant growth assumption—the formula $P_0 = \frac{D_1}{r - g}$ assumes dividends grow at rate $g$ forever
• Only valid when $g < r$—if growth exceeds the discount rate, the model breaks down mathematically
• Best for mature, dividend-paying companies like utilities or consumer staples with predictable, slow-growth profiles

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Market-Based Methods

These methods derive value from what the market pays for similar companies or transactions. The principle: comparable assets should trade at comparable prices, adjusted for differences in size, growth, and risk.

Comparable Company Analysis (Multiples Method)

• Applies valuation multiples from peer companies—common multiples include P/E, EV/EBITDA, and EV/Revenue
• Reflects current market sentiment—captures what investors are actually paying today, including any market-wide premiums or discounts
• Selection of comparables is critical—poor peer selection undermines the entire analysis; match by industry, size, growth rate, and profitability

Precedent Transactions Method

• Uses multiples from actual M&A deals—shows what acquirers historically paid for control of similar businesses
• Includes control premiums—transaction prices typically exceed trading multiples by 20-40% because buyers pay for control
• Data availability limits usefulness—relevant transactions may be scarce, and market conditions at deal time may differ significantly from today

Market Capitalization Method

• Simply multiplies share price by shares outstanding—the market's real-time verdict on equity value
• Reflects public perception, not necessarily intrinsic value—subject to market volatility, sentiment swings, and information asymmetry
• Only applicable to publicly traded companies—private firms require other methods to estimate equivalent market value

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Asset-Based and Performance Methods

These approaches focus on what a company owns or how efficiently it creates value. The logic: value can be derived from the balance sheet or measured by economic profit generation.

Asset-Based Valuation

• Calculates net asset value—fair market value of all assets minus liabilities, including both tangible and intangible assets
• Sets a floor value—particularly relevant in liquidation scenarios or for asset-heavy businesses like real estate or manufacturing
• Misses going-concern value—doesn't capture earning power, brand equity, or growth potential that operating businesses possess

Economic Value Added (EVA)

• Measures true economic profit—calculated as $EVA = NOPAT - (Capital \times WACC)$, showing whether returns exceed the cost of capital
• Directly ties to shareholder value creation—positive EVA means the business earns more than its investors require
• Useful for internal performance evaluation—helps managers assess whether investments and business units actually create value

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Quick Reference Table

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Self-Check Questions

1. Which two valuation methods explicitly separate the value of tax shields from operating value, and when would you choose one over the other?

2. A private equity firm is evaluating an LBO target. Which valuation methods would be most appropriate, and why might market capitalization be insufficient?

3. Compare and contrast the Gordon Growth Model and multi-stage DDM—what company characteristics would lead you to choose each approach?

4. If an FRQ presents a company with minimal physical assets but strong recurring subscription revenue, explain why asset-based valuation would understate value and which alternative method you'd recommend.

5. How does the inclusion of control premiums differentiate precedent transactions from comparable company analysis, and what does this imply for valuing a minority stake versus a controlling interest?