Assessing the value of a company is part art and part science. However, there are two widely accepted ways of doing it more scientifically: relative and intrinsic valuations. Used together, these methods can help investors gauge a company’s current market value and then assess if that company is under- or overvalued.

Assumptions must be made either way—especially when the business is privately owned. The reason for this is simple: Private companies aren’t required to disclose the same level of detailed financial information that publicly owned businesses are. With so many variables, it’s easy to see why pricing a deal can be difficult and why most investors and transaction advisors choose to use both types of valuation models to inform their decision-making.

Here’s a quick overview of how relative and intrinsic business valuations work.

Relative valuations

As the name suggests, relative valuation methods use comparative reasoning. They try to establish the value of a business based on the value of its industry peers. This helps investors and transaction advisors establish a company’s current market value.

It’s similar in concept to how home appraisals work: You start by looking at the property (read: company) you’re trying to assess the value of, then you look for several comparables in the neighborhood to determine how the property you’re appraising stacks up against them based on a series of defined variables.

For relative business valuation models, those defined variables are expressed as financial multiples, averages, ratios and benchmarks. The implied assumption: The company that’s being valued should have the same—or at least similar—multipliers as its competitors.

Types of relative business valuation models

  • Comparable company analysis (public comps)—evaluates similar, publicly owned companies’ valuation metrics that are determined by current market prices.
     
  • Precedent transaction analysis (M&A comps)—looks at historical prices for completed deals within the private markets that involve similar companies.

Intrinsic valuations

Intrinsic valuations examine the value of a company based on its projected cash flows without comparing it to any other businesses. While inherently subjective, this valuation method helps investors to gauge how much money they might receive from an investment, adjusted for the time value of money—assuming a dollar invested today is worth more than a dollar tomorrow.

When used in conjunction with relative valuation models, intrinsic valuation methods also offer an effective way for investors to assess if a company is currently under- or overvalued in the market and to more accurately gauge how much opportunity there potentially is by investing in it.

Types of intrinsic business valuation models

  • Discounted cash flow (DCF) analysis—establishes a rate of return or discount rate by looking at dividends, earnings, operating cash flow or free cash flow that is then used to establish the value of the business outside of other market considerations.
     
    • Weighted average-cost of capital analysis—is usually a part of a DCF analysis and accounts for the time value of money to establish an expected rate of return on a potential investment.
       

Want to learn more about how you can leverage private market data to mitigate investment risk? Read our full market brief.

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