I am evaluating a company stock using 2 approaches: DCF ( FCFF- market value of debt) & Multiples (P/E & EV/EBITDA. Now I have to weight each valuation to generate a price. Based on what theory or what factors or justification could I use to weight ?
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I usually weight different methodologies based on my subjective comfort around each one. I prefer DCFs, so I usually weight those more heavily than multiples.
I was waiting to see what other contributions came to this thread.
dspapo’s nailed it: it depends on how much confidence you place in each methodology. If they’re about equal, go 50-50 (more or less). If you strongly prefer DCF to multiples (noting that multiples are a relative valuation method, not an absolute valuation method), then you may go 80-20 DCF (or so). This is clearly a subjective area of valuation: give each the weight with which you feel most comfortable.
By the way, how different are the valuations?
I would tend to disagree, slightly. While subjective comfort is important, your approach needs to withstand scrutiny. Scrutiny from your team, your boss, your client, or even a court (this is where I have the majority of my experience). If you assign, say, 80pct weight to your DCF and 20pct weight to your market approach, you better have a better answer than: Well, that’s just what I’m comfortable using. Moreover, you should also have an answer to this question (assuming your market approach truly is steeped in guideline public comps): Why do you place more reliance on a DCF model that is based on dozens of challengeable/unobservable assumptions when a market-based approach is more supportable/observable? If you can answer both of these comfortably and convincingly, have at it.
+1.
If this goes to tax court, and they asked you, “You came up with two valuations–one for $5m and the other says $2m. You weighted them 80% to the $2m and 20% to the $5m. Why?” You better have a darn good answer, or be prepared to tell your client “Sorry, but I just lost you $315,000.” ($315k is the 35% of the difference between an 80/20 weighting and an arbitrary 50/50 weighting.)
Sorry: I wasn’t trying to suggest that your confidence is some sort of gut feel.
You’re correct: you need to justify your confidence; I (implicitly) assumed you could do that.