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One of the key principles underlying the world of finance is that money has a 'time value'. In general, we value money that we have today more highly than money we might receive in the future. This is due to a number of reasons including:
- Our preference to consume now rather than later (hence we need money now!)
- The opportunity to use money now to invest and earn a return
- The fact that currency seems to depreciate overtime (inflation; sometimes more faster than other times)
- The uncertainty about whether we will get the money in the future
These factors mean that we will discount future values or benefits when assessing them today. If we add to this the understanding that an asset is simply something in which we have the ability to earn a future benefit then, in principle we can value any asset today by simply discounting its future benefits (or cash flows) back to today and adding them together. This is known as a discounted cash flow (DCF) valuation and it is the bedrock of business and asset valuation.
The one problem with conducting a DCF is the need to forecast the future. This can be difficult at the best of times, especially for assets in which benefits are expected to flow for a long time (for example, shares in a business might last centuries). To get around this, analysts will often rely upon easier approaches to value assets. These usually rely on market transaction data and comparables, and will often turn a valuation from a complex spreadsheet model into a quick calculation.
The main types of simpler valuation approaches include the use of valuation multiples, which include:
- Price-to-earnings (P/E) ratios - This is a key tool used by investors that is based on reported and forecasted earnings per share and market stock prices. The average range for P/Es over history has been between 10 and 25, with higher ratios representing more expensive companies. P/E's can be used by analysts to value companies by accessing market P/E ratios of comparable companies and multiplying earnings by a company's earnings
- Earnings before interest and tax (EBIT) and earnings before interest, tax, depreciation and amortisation (EBITDA) multiples - These multiples work in a similar way to P/E ratios and are based on industry transaction data (rather than share market data). EBIT/EBITDA multiples are, thus, often applied to the valuing of private equity and other unlisted companies. Using earnings stripped of interest, tax, depreciation or amortisation helps to value the operations of a business and removes non-operational decision-making or circumstances (e.g. level of leverage, accounting approaches)
- Capitalisation (cap) rates - Cap rates are often used in the property industry and are a divisor rather than a multiple (i.e. you divide net earnings by the cap rate to get the value). Like with other multiples, applicable cap rates are determined by recent transactions of similar assets.
Other than simplicity, one other advantage that valuation multiples have over a DCF is that there are fewer assumptions that need to be made. However, it should be noted, that simplifying assumptions can often lead to valuations that miss the important nuance inherent in a complex world.
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