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DCF Method
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Comparing Multiples and DCF
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When you want to estimate the value of a business, you have two main methods to choose from: multiples and discounted cash flow (DCF). Both methods have their advantages and disadvantages, depending on the context and purpose of your valuation. In this article, you will learn the basics of each method, and how to compare and contrast them for different scenarios.
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1 Multiples Method
The multiples method is based on the idea that similar businesses should have similar values, relative to some common measure. For example, you can compare the price-to-earnings (P/E) ratio of different companies in the same industry, and apply the average or median ratio to the target company's earnings to get an estimate of its value. Other common multiples include price-to-sales, price-to-book, and enterprise value-to-EBITDA. The advantages of using multiples are that they are simple, quick, and widely available. You can easily find comparable companies and their financial data from public sources, and calculate the multiples with minimal assumptions. The disadvantages of using multiples are that they can be misleading, inconsistent, and subjective. You may not find truly comparable companies, or you may have to adjust for different accounting practices, growth rates, risk profiles, and capital structures. You may also have to choose which multiple to use, and how to weight them, based on your own judgment and preferences.
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2 DCF Method
The DCF method is based on the idea that the value of a business is equal to the present value of its future cash flows. To use this method, you have to project the cash flows of the target company for a certain period, usually five to ten years, and then estimate its terminal value at the end of that period. You then discount these cash flows and the terminal value by a discount rate that reflects the risk and opportunity cost of investing in the business. The advantages of using DCF are that it is more comprehensive, flexible, and intrinsic. You can capture the specific characteristics and drivers of the target company's performance, and adjust for different scenarios and assumptions. You can also derive the value from the fundamentals of the business, rather than from the market conditions or sentiments. The disadvantages of using DCF are that it is more complex, time-consuming, and sensitive. You have to make many assumptions and projections, which may not be accurate or reliable. You also have to estimate the discount rate and the terminal value, which can have a significant impact on the final value. You may also face challenges in validating and communicating your DCF model to others.
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3 Comparing Multiples and DCF
The choice between multiples and DCF depends on several factors, such as the availability and quality of data, the purpose and audience of your valuation, and the nature and stage of the business. In general, multiples are more suitable for quick and rough estimates, for benchmarking and relative valuation, and for mature and stable businesses with clear peers. DCF is more suitable for detailed and precise estimates, for intrinsic and absolute valuation, and for growing and unique businesses with uncertain prospects. However, you should not rely on one method alone, as each method has its limitations and biases. You should use both methods to cross-check and validate your results, and to understand the range and drivers of value. You should also be aware of the assumptions and uncertainties behind each method, and use sensitivity analysis and scenario analysis to test them.
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