Valuing a company: discounted cash flow against comparable multiples

CB1 · Business Finance · 10 min read

The two approaches, and what each one really is

A company is worth what its future cash is worth today. That sentence is the whole of valuation theory, and it is useless on its own, because nobody knows the future cash.

So there are two practical responses. Discounted cash flow forecasts the cash explicitly and discounts it — building the answer from the ground up out of assumptions you have chosen and can be held to. Comparable multiples look at what the market pays for similar companies and apply the same ratio — borrowing the answer from prices somebody else has set.

Neither is more rigorous than the other, and a good answer in this topic resists the temptation to say so. A discounted cash flow looks rigorous because it has arithmetic in it, but its answer is driven almost entirely by two numbers you guessed. A multiple looks crude, but it is anchored to real transactions.

Discounted cash flow: the mechanics

Forecast the free cash flow to the firm — the cash the business generates for all its investors, before any financing. It is operating profit, less tax, plus depreciation and other non-cash charges, less capital expenditure, less the increase in working capital.

Discount it at the weighted average cost of capital, because it is cash available to debt and equity together and must be discounted at the blended rate those two require.

Nobody forecasts to infinity. The practical structure is an explicit forecast for a handful of years and then a terminal value standing for everything after it, usually as a growing perpetuity:

In words: the cash flow in the first year beyond the forecast, divided by the amount by which the discount rate exceeds the growth rate. That denominator is where the sensitivity lives: with a rate of 10% and growth of 4% it is 6%, and moving growth by one point moves the terminal value by about a fifth.

Then, to get from the company to the shares:

Mixing those two up is the commonest error in the topic. An enterprise value belongs to everybody who financed the business; an equity value belongs to the shareholders alone; and net debt is the bridge.

The uncomfortable fact about the terminal value

On ordinary assumptions the terminal value is most of the answer — three quarters of it in the worked example below. So a five-year forecast built with great care contributes a quarter of the valuation, and the other three quarters come from two numbers: a perpetual growth rate and a discount rate.

That is not an argument against the method. It is an instruction about where to spend your attention, and about what a sensitivity analysis is for. A valuation presented without one is presenting a single number as though it were known.

One discipline worth stating: the perpetual growth rate cannot exceed the long-run growth rate of the economy the company operates in. A company growing faster than its economy forever eventually becomes the whole economy. And if g is set above the discount rate the formula returns a negative value, which is the arithmetic refusing an impossible assumption rather than a result.

Comparable multiples: the mechanics

Find companies that are genuinely similar, compute a ratio of value to some fundamental, and apply the ratio.

Price to earnings is the familiar one: equity value divided by profit after tax. It is an equity multiple, so it gives an equity value directly and net debt must not be subtracted again.

Enterprise value to EBITDA is often preferred for comparison because it is computed before interest, tax, depreciation and amortisation, so it is not distorted by how companies are financed or how fast they depreciate. It gives an enterprise value, so net debt must be subtracted to reach the equity.

The judgement is entirely in the word "similar". A multiple imports everything about the comparator companies: their growth, their risk, their gearing, their accounting policies and the market's current mood about their sector. If they differ from your company in any of those, the multiple is wrong by an amount nobody can calculate.

Why a multiple is a discounted cash flow in disguise

Worth seeing once, because it stops the two methods feeling like unrelated tricks. Take a company paying out all its earnings, growing at g, with a cost of equity ke. Its value is E/(ke − g), so

A price-earnings ratio is a statement about growth and risk, compressed into one number. A company on a higher multiple than its peers is one the market expects to grow faster or judges to be safer — and asking which is the useful question when you find a difference.

Where marks are lost

Discounting free cash flow to the firm at the cost of equity. Cash for all investors, discounted at the blended rate. Cash for shareholders only, discounted at the cost of equity. Crossing them over is a large error, not a rounding one.

Forgetting to subtract net debt, or subtracting it twice. Decide whether your multiple or model produced an enterprise value or an equity value, write it down, and then bridge once.

Using the forecast year's cash flow in the terminal value. The formula needs the cash flow of the year after the forecast ends. Using year n instead of year n+1 understates the terminal value by a factor of (1 + g).

Discounting the terminal value by the wrong number of years. A terminal value computed at the end of year 5 is discounted five years, not six.

Setting a perpetual growth rate above the discount rate. Or anywhere near it. Check the denominator before believing the answer.

Averaging a multiple over comparators that are not comparable. The average of six wrong numbers is a wrong number with a false air of robustness.

Questions students ask

Which method should I use in an exam?

Whichever the question's data supports, and then say what the other would add. If you are given forecasts and a cost of capital, the question wants a discounted cash flow. If you are given a peer group's multiples, it wants a comparison. If it gives you both, the marks are in the reconciliation: naming which assumption drives the gap.

What if the two methods disagree?

Then you have learned something, and the answer is to say what. A discounted cash flow above the multiples means your forecasts are more optimistic than the market's view of similar companies — which may be right, but needs defending. The disagreement is the finding; splitting the difference is not.

Why is a loss-making company hard to value this way?

Because a price-earnings ratio on negative earnings is meaningless and a discounted cash flow has to forecast the turn to profit, which is the part nobody can do. Revenue multiples and real-option thinking are the usual substitutes, and both are weaker. Being able to say why the standard tools fail is worth more than producing a number from them.

A worked example

An invented company. Every figure is made up for this example and describes no real business or market. All amounts are in ₹ crore.

Shringar Tools Limited is being valued. Its free cash flow to the firm next year is forecast at ₹120 crore, expected to grow at 4% a year indefinitely. Its weighted average cost of capital is 10%. It has net debt of ₹500 crore and profit after tax of ₹100 crore.

Route one: the growing perpetuity, in one line

Route two: five explicit years plus a terminal value

This is how a valuation is actually built, and doing it the long way on a case where the short way is available is the best check there is.

Each year's cash flow is the previous one times 1.04: 120 × 1.04 = 124.8000, 124.8 × 1.04 = 129.7920, and so on.

Now the terminal value, which needs the cash flow of year 6:

The same ₹2,000 crore to four decimal places. It has to be: a growing perpetuity split into its first five years and everything after them is still the same perpetuity. If a build-up of yours does not reproduce the one-line answer on a constant-growth case, the terminal value has the wrong cash flow in it or the wrong number of years of discounting — which are the two errors this check is built to catch.

Where the answer came from

Three quarters of the valuation is the assumption that a business grows at 4% forever, discounted at 10%. The five years of forecasting that look like the work contribute a quarter. That is worth saying out loud to anyone who is handed a valuation, and it is why the sensitivity table below is not optional.

One percentage point on a number nobody can observe moves the answer by 14% downwards or 20% upwards. A valuation quoted as ₹2,000 crore without that range is quoting a precision it does not have.

From the company to the shares

Route three: the comparable multiple

Suppose similar listed companies trade on a price-earnings ratio of 15. Applying it to this company's profit after tax:

Which agrees with the discounted cash flow. Two methods, two completely different sets of inputs, the same ₹1,500 crore.

Be careful about what that agreement is worth. It does not confirm the forecasts. It says the market's view of similar companies and this model's assumptions happen to imply the same price — which is reassuring, and is the main practical use of a multiple: a cross-check on a model whose own inputs cannot be verified.

And note the bridge, since it is where the marks go. The multiple gave an equity value, so the ₹500 crore of net debt must not be subtracted from it. Adding it back the other way confirms the two are consistent on an enterprise basis: 1,500 + 500 = ₹2,000 crore, the discounted cash flow answer.

What the multiple is saying underneath

A price-earnings ratio of 15 implies, for a company paying out all its earnings,

The market is pricing these companies as though the gap between what shareholders require and what the business grows at is about six and two-thirds per cent. That is remarkably close to the 6% gap the discounted cash flow used, and it is the reason the two answers landed together. The agreement was not a coincidence; the two models are carrying almost the same assumption, one of them in the open and one of them hidden inside a ratio.

Where this fits in CB1

This page explains one idea from CB1 Business Finance. The full CB1 syllabus, with what each part is examined on, sits on the course page, and past-paper style mock exams with full solutions are where you find out whether the idea has stuck under time pressure.

Other CB1 topics explained

• Why financial reporting is regulated, and who it is regulated for
• Share capital and loan capital: why each source costs what it does
• Leasing against buying, and the only comparison that settles it
• Profit is not cash, and why a growing company can run out of money
• Return on capital employed, and the two things that drive it
• Gearing: why borrowing magnifies a shareholder return in both directions
• Modigliani-Miller: why gearing does not create value, and what does
• Dividend irrelevance, and the four reasons dividends still matter
• The cost of capital, and why a project must beat the whole pot
• NPV against IRR, and the three times IRR gives the wrong answer
• Working capital: the days between paying out and being paid
• Synergies and the takeover premium: who actually gets the gain
• Company tax in an appraisal, and the relief that reverses the answer
• Interest rate swaps: fixing a floating cost, and where the saving comes from
• Hedging currency risk: the forward contract and the money-market hedge

Stuck on a term rather than the idea? The actuarial glossary defines the notation used above. If something here is wrong or unclear, tell us — these pages get corrected.