S 4 Formulas And Models Investors Can Use To Valuate Companies In 2022

Valuing assets is a skill that every investor must have. There are just as many valuation models as there are assets these days, and to the beginner investor, all of this can seem intimidating. However, there are a few tried and tested valuation models that always work.

While these models are powerful, it's important to note that none of them offers a magical solution. Investors must conduct their due diligence thoroughly and adjust inputs to these models as appropriate. At the end of the day, these models are only as good as the data they're fed.

So having said that, let's jump in and look at four valuation methods that will always stand you in good stead.

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Discounted Cash Flow Analysis

What is “discounted cash flow,” and why is it a popular method of valuing assets? DCF analysis is useful for determining the value of not just companies and cash-producing assets. It is also used by organizations when trying to figure out the most profitable internal initiative to pursue.

The premise behind a DCF is simple. The model uses cash flows generated by an asset to give it a dollar value. The underlying principle a DCF uses is the time value of money, which states that a dollar today is not worth a dollar tomorrow due to inflation and other costs.

A DCF nicely brings all cash flows that an asset is expected to produce in the future together with its current price to give investors a dollar figure that acts as a final value they ought to pay for the asset. A huge input that skews final asset values is the discount rate or the risk-free rate.

This number, expressed as an interest rate, represents the rate of risk-free return an investor can receive by placing their money in an alternative asset. Some investors use it as a hurdle rate as well, using it to indicate the minimum interest they'd like to receive from the investment. Accountants and cash flow analysts further use the discount rate differently.

As far as investors are concerned, the best approach to take is to use it as a risk-free rate, since this gives you a good margin of safety when evaluating how much you ought to pay.

Owner Earnings

Owner earnings is a phrase Warren Buffett made popular through his shareholder letters. It's a number that Buffett has used to determine the true cash flow an owner receives after investing in a business. The formula to calculate owner earnings is straightforward.

It is equal to the sum of net income reported, changes in working capital, and non-cash charges from which annual average capital expenditures are subtracted. Divide this number by the number of shares outstanding, and you'll receive the owner earnings per share.

Compare this to the current price and net income per share to figure out how over or undervalued the asset is.

There are a few moving parts to this formula that deserve an explanation. First, non-cash charges such as depreciation and amortization are added back to net income because they don't represent actual cash flowing out of the business. Owner earnings also emphasize changes in working capital, a number that can be found on the cash flow statement these days.

The company's capital expenditures are also treated as an expense. Note that this number is equal to the average capital expenditure needed to maintain the business, not the full dollar value. Investors will need to understand the business well to approximate this number.

The final amount of owner earnings is thus subjective. This makes it important for an investor to fully understand how a business works and estimate numbers appropriately.

SDE-Based Valuation

Seller's discretionary earnings or SDE is similar to owner earnings in concept, even if the formula is different. SDE is calculated by adding one-time expenses, non-recurring expenses, and the owner or family-related expenses back to EBITDA.

This valuation method applies mostly to small to midsize businesses whose owners are in touch with the ups and downs of their company. Typically, small business owners encounter a variety of non-traditional expenses that accounting rules penalize them for.

This method also works well for startups that encounter high costs initially. The model also lends itself well to SaaS-based companies that have non-traditional billing cycles.

Given the discretionary nature of the additions and subtractions in this method, investors need to understand the business well before using SDE.

EBITDA Valuation

EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, is a long-standing valuation metric that companies have used. The formula is straightforward. Simply add back interest, taxes, depreciation, and amortization to net income to arrive at EBITDA.

Despite its simplicity, there are many pitfalls to EBITDA that investors must watch out for. For starters, neglecting interest expenses can prove catastrophic if debt levels are high. Also, asset-heavy companies generally have heavy depreciation and amortization expenses that must be accounted for.

However, given the ease of calculating this number, many investors prefer it to get a quick snapshot of business value.

Many Valuation Methods

There are many ways of valuing a business, but the four methods highlighted in this article are evergreen. Use them to quickly capture a snapshot of business value, and you'll understand how much you ought to pay for a cash flow-backed asset.

Disclosure: The material appearing on this article is based on data and information from sources I believe to be accurate and reliable. However, the material is not guaranteed as to accuracy nor does ...

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