Finance Tutor addresses the article from the perspective of testing the valuation concepts you learn in business school. With their permission, I repost finance Tutor’s article here.
You learn the about business valuation in business school. But are the business valuation concepts you learn in business school used in business valuations in the real world? Lets check a current business valuation:
You must have heard about Google’s interest in buying Groupon’s business at a reported valuation of $5-6 Billion! How could Google arrive at this business valuation of Groupon’s business? Valuation principles direct us to use either the discounted cash flow method orvaluation multiples method to arrive at business valuations.
Business Valuations using the Discounted Cash-flow Method
To arrive at business valuation using the Discounted Cash-flow (DCF) process, we need to project out the cash flow of the business into the foreseeable future. We discount this cash flow at the appropriate discount rate to arrive at the present value of cash flows for this valuation period. We then estimate a terminal value (present value of the cash flow beyond the foreseeable future assuming cash flow grows at a constant rate usually inflation rate or slightly higher). The sum of the present value of cash flows for the foreseeable valuation period and the terminal value form the basis of the business valuation using the DCF method.
Can we estimate Groupon’s business value using the DCF method? We will need detailed projections of Groupon’s future cash flow which we do not have! We can try arrive at the business valuation with some estimates. But why do this when we have an easier approach?
Business Valuations using the Multiples
Business valuations using the valuation multiples is essentially looking at the business valuation similar companies have obtained recently and relating that to known business metrics like sales, earnings per share, customers, etc. Groupon does not have any comparable companies with publicly available data. We therefore need to look at companies with similar business characteristics, growth rates, profit margins, etc to arrive at the appropriate valuation multiples.
Part 2 of this post shows you how valuation multiples can be used to arrive at the business valuation of Groupon.