Corporate Valuation McKinsey Methods for Accurate Multiples

McKinsey's corporate valuation methods are renowned for their accuracy and effectiveness. One of the key methods used is the Comparable Companies Analysis, which involves selecting a group of similar companies to the one being valued.

This analysis helps to determine the market value of the company by comparing its financial metrics to those of its peers. According to McKinsey, the selection of comparable companies is crucial to the success of this method.

The Enterprise Value-to-EBITDA multiple is a key metric used in the Comparable Companies Analysis. This multiple is calculated by dividing the enterprise value of a company by its EBITDA, or earnings before interest, taxes, depreciation, and amortization.

A higher multiple typically indicates a more valuable company, while a lower multiple suggests a less valuable one.

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The key to identifying value drivers lies in understanding the relationship between free cash flow, equity value, and enterprise value. Equity value is determined by the formula Equity Value = Div1/(k-g), where Div1 is the sustainable dividend growth.

Dividend growth is influenced by the company's ability to retain cash and earn returns, which is reflected in the formula g = (1 – DPO) x ROE. The dividend payout ratio (DPO) is also a crucial factor, as it determines how much of the company's earnings are distributed to shareholders.

A low DPO can lead to higher dividend growth, as more cash is retained to reinvest in the business. This, in turn, can increase the company's value.

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The value driver formulas are based on simple integral calculus, starting with the classic formula that applies free cash flow: Equity Value = Div1/(k-g). This is the foundation for understanding how value drivers work.

In the world of finance, free cash flow is a crucial metric. The Enterprise Value formula, Free Cash Flow1/(WACC-g), shows how it's used to calculate enterprise value.

To compute the cost of equity capital, you can rearrange the formula: (k-g) = (1-g/ROE)/PE. This is a key concept in understanding value drivers.

Sustainable dividend growth is a critical aspect of equity value. The formula g = (1 – DPO) x ROE shows how it's calculated. This is essential for re-arranging the formula to compute dividends as a function of earnings and DPO.

For equity, the formula Value = Div1/(k-g) can be re-arranged to compute the P/E Ratio, which works best with forward P/E. The ratio is (1-g/ROE)/(k-g).

The Price to Book Ratio formula is Value = BV * (ROE – g)/(k-g). This is a crucial metric for understanding value drivers.

The implied formula for Cost of Capital with Price to Book Formula is k=(ROE-g)/PB+g. This shows how the cost of capital is calculated using the Price to Book Ratio.

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In some industries, shifts in demand can have a profound impact on company cash flows and valuations.

The upstream oil and gas industry is one such example, where falling demand due to cleaner energy sources and increased energy efficiency could lead to a 5-15% drop in valuations.

Companies in the building-materials sector, on the other hand, are likely to benefit from rising demand for energy efficiency and insulation products, with valuations increasing by 35-80% in developed economies.

A dramatic decline in demand could push down prices and further reduce the value of cash flows affected.

More stringent building standards in developed economies are already creating demand for improved energy efficiency and insulation products, with analysts factoring this into company valuations.

As regulatory and policy events unfold, the uncertainty surrounding carbon reduction efforts will decrease, and the impact on valuations across various industries will become clearer. The Copenhagen conference in December 2009 is a notable example of such an event.

Major shifts in valuations will start to become predictable over the next 18 to 24 months, as companies and nations take more aggressive actions to reduce carbon emissions. This will lead to significant changes in the value of companies in various sectors.

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The immediate impact on cash flows might be limited, but it will eventually be substantial in some industries. Companies need to position themselves to thrive in a low-carbon economy.

Several regulatory and policy events are expected to reduce uncertainty and spark a rethinking of how carbon reduction efforts will affect valuations.

Structural resilience is a key factor in identifying value drivers. Some sectors will experience minimal long-term stress from carbon-abatement efforts.

The consumer electronics industry is a great example of this. It can pass along short-term cost pressures to customers and won't face significant shifts in demand.

Using existing technologies, the industry can make its products dramatically more efficient at low and diminishing costs. This will help it deal with regulation without harming its bottom line.

Increased efficiency-improvement pressures, including limits on standby and active power consumption, will be a challenge for the industry. However, the overall impact on its value will be limited.

In fact, some of its revenue and margin opportunities could have a positive impact of up to 10 percent on its discounted cash flows in the executive scenario.

To prepare for valuation, it's essential to forecast long-term operating margins, required capital investments, and return on invested capital (ROIC). This can be done by examining the fundamentals of your business model and looking to companies with similar models, like OpenTable, which aims to reach operating profit margins of about 25 percent.

Yelp's capital requirements are a notable example, with the company requiring only 24 percent of its revenue in capital in 2014. This is in line with other Internet companies like Google and LinkedIn, and is a key factor in Yelp's high ROIC.

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To estimate the value of a company, we need to forecast its future financial performance. This involves estimating key financial metrics such as operating margin, capital intensity, and return on invested capital (ROIC).

Operating margin is a crucial metric that measures a company's profitability. According to the article, OpenTable's management forecast that it would reach operating profit margins of about 25 percent when mature. This translates to a potential growth in operating profit from a loss of $8.1 million in 2013 to a profit of $619 million in 2023.

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We can also look at the operating margins of similar companies to get an idea of what's possible. For instance, Google has maintained healthy margins over the years, which is a good benchmark for companies like Yelp.

Capital intensity is another important metric that measures the amount of capital required to grow a business. Yelp required only $92 million of capital on $378 million of revenues in 2014, or 24 percent. This is a relatively low capital intensity compared to traditional companies.

ROIC is a useful metric that measures a company's ability to generate returns on its invested capital. However, Yelp's high operating margins and low capital intensity make ROIC less useful as a measure.

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Developing weighted scenarios is a crucial step in preparing for valuation. This involves creating hypothetical scenarios that reflect different potential outcomes for your business.

A good starting point is to identify key drivers of value, such as revenue growth, profitability, and market share. For example, a business with a strong track record of revenue growth may be more attractive to investors than one with stagnant sales.

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Weighted scenarios should also consider the likelihood of each outcome, with more probable scenarios given greater weight. This can be done by assigning a probability score to each scenario, such as 0.5 for a high-probability outcome and 0.1 for a low-probability outcome.

To get a more accurate picture, consider different scenarios for various time horizons, such as short-term, medium-term, and long-term. This will help you anticipate potential changes in the market and adjust your valuation accordingly.

The value of preparation is crucial in a low-carbon economy. Much uncertainty remains over the course of regulation and the pace of change for climate change-related forces, such as technology, that will influence abatement levels.

Companies will need to focus on how and when to signal the value of their climate change bets so that investors can assess them. Each company will have to explain its overall level of preparedness for the future.

The immediate impact on cash flows (and therefore discounted valuations) might be limited, but it will eventually be significant in some industries. Over the next 18 to 24 months, a number of regulatory and policy events will reduce the uncertainty and spark a rethinking of how carbon reduction efforts will affect valuations across a wide range of industries.

Several steps can help companies and their executives as they start to position themselves to thrive in a low-carbon economy.

Using multiples can be a useful way to estimate a company's value, but it's not without its challenges. Multiples can be misleading if not used correctly.

For example, if you're using P/E ratios, you need to be aware that different multiples can suggest conflicting conclusions. Best Buy trades at a premium to Circuit City Stores using their respective enterprise-value multiples, but at a discount according to their P/E ratios.

To choose the right companies, you have to match those with similar expectations for growth and ROIC (Return on Invested Capital). The Home Depot and Lowe's, for instance, traded at nearly identical multiples, but that similarity doesn't extend to a larger set of hard-lines retailers.

Enterprise-value multiples, on the other hand, are less susceptible to manipulation by changes in capital structure. This makes them a more reliable alternative to P/E ratios.

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Forward-looking multiples are more accurate predictors of value than historical multiples.

Empirical evidence shows that forward-looking multiples are more accurate than historical multiples. Jing Liu, Doron Nissim, and Jacob Thomas compared historical and forward industry multiples for a subset of companies trading on the NYSE, the American Stock Exchange, and Nasdaq.

The dispersion of historical earnings-to-price (E/P) ratios was nearly twice that of one-year forward E/P ratios.

Forward-looking multiples promoted greater accuracy in pricing. The median pricing error for historical multiples was 23 percent, compared to 18 percent for one-year forward multiples.

Two-year forecasts cut the median pricing error to 16 percent.

Similarly, Moonchul Kim and Jay Ritter compared the pricing power of historical and forecast earnings for 142 initial public offerings.

The average prediction error fell from 55.0 percent to 28.5 percent when moving from multiples based on historical earnings to multiples based on one- and two-year forecasts.

The percentage of companies valued within 15 percent of their actual trading multiple increased from 15.4 percent to 36.4 percent when using forward-looking multiples.

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AOL Time Warner's write-off of nearly $100 billion in goodwill and other intangibles in 2002 is a prime example of how nonoperating items can distort the P/E ratio.

The P/E ratio isn't meaningful when earnings are negative, as was the case with AOL Time Warner that year. Its EBITA equaled $6.4 billion, but it recorded a $98 billion loss.

Enterprise-value-to-EBITA multiples are generally less susceptible to manipulation by changes in capital structure. This is because enterprise value includes both debt and equity, and EBITA is the profit available to investors.

A change in capital structure will have no systematic effect on enterprise-value-to-EBITA multiples, unless it lowers the cost of capital, which can lead to a higher multiple.

Finding the right companies for a comparable set is challenging. Most financial analysts start by examining a company's industry, but industries are often loosely defined.

A better approach is to use a proprietary system like the Global Industry Classification Standard (GICS), developed by Morgan Stanley Capital International and Standard & Poor's.

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To create a more accurate peer group, you must examine each company on the list and answer critical questions about their strategic advantages, such as superior products, better access to customers, or recurring revenues.

You must become an expert on the operating and financial specifics of each company, including their products, revenue and profit generation, and growth strategies.

A company's multiple will appear in the right context with other companies only when you have that expertise. In some cases, your final analysis may come down to just one company, like evaluating Home Depot, where only Lowe's remains as a comparable.

Poor video quality can be a concern, as seen in some of the videos linked in the article section. The videos demonstrate biases and errors in the value driver formula.

Biases can arise when the return on new assets is different from the return on existing assets, as shown in one of the videos. This can lead to inaccurate valuations.

To avoid common pitfalls, it's essential to consider the impact of inflation on the value driver formula, as demonstrated in the file "Inflation and Value Driver Formula.xlsm". This file addresses the value driver formula and its limitations.

Here are some common pitfalls to watch out for:

By being aware of these potential pitfalls, you can take steps to avoid them and ensure more accurate corporate valuations.

Multiples can be misleading if not used correctly. For instance, when comparing the valuations of Home Depot and Lowe's, their P/E ratios differed by only 8 percent, but their enterprise-value-to-EBITDA ratios differed by only 3 percent.

This similarity doesn't extend to a larger set of hard-lines retailers, whose enterprise multiples vary from 4.4 to 9.9. This is because investors have different expectations about each company's ability to create value going forward.

Investors must pay attention to growth and returns on capital to avoid misusing multiples. Companies that achieve growth objectives but forfeit the benefits of a higher P/E ratio can happen if executives and investors don't consider these factors.

Different multiples can suggest conflicting conclusions, such as Best Buy trading at a premium to Circuit City Stores when measured using enterprise-value multiples, but at a discount according to P/E ratios.

The value driver formula is a powerful tool for financial analysis, but it's not immune to biases and errors. A video on the left in the article section shows how errors associated with inflation can impact the value driver formula.

Inflation can significantly affect the value driver formula, as seen in the video on the left. To avoid this, it's essential to consider inflation when using the formula.

The value driver formula can also be biased when the return on new assets differs from the return on existing assets. This is demonstrated in the video on the right in the article section.

There are several videos that demonstrate how the value driver formula works, but some of these videos have poor quality. The links to these videos are provided in the article section.

Some of the videos that demonstrate biases and errors in the value driver formula include:

These videos can be accessed through the provided links in the article section.