I worked as a valuation associate at a private equity firm for 2 years. During that time I learned the art and the science of valuing public and private companies.

As you may have noticed, multiples across the board are down.

What I’d like to do is discuss mechanically why this is the case. In this post we’ll de-mystify the 3 most common ways companies are valued. And we’ll do it in plain English.

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There are 3 popular ways to value a company:

#1 falls into the Intrinsic Valuation bucket. You look at what the company is valued at on it’s own. This requires the most detailed analysis of the bunch.

#2 and #3 fall into the Relative Valuation bucket. They rely on what other companies have done, and are based on publicly available information.

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Analogy: When someone wins the lottery they have two payout options:

-Annuity: Get paid a fixed dollar amount every year, similar to a business owner taking a salary from the company’s profits

-Lump Sum: Take it all now in one big slug, equal to the sum of those future Annuities discounted back to a smaller present value

Now imagine the discount rate applied to the lump sum payout goes up. This is exactly what’s happening in DCF models, due to rising interest rates, and pushing present valuations down.

DCF models use a Weighted Average Cost of Capital (WACC) to discount future cash flows. When interest rates go up, the Risk Free Rate, a component of the WACC, goes up. Applying a higher WACC to your forecast decreases the company’s terminal value.

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Analogy: A rising tide tends to lift all ships, but you find out whose swimming naked when the tide goes out.

Why It Matters: As addressed above, models are getting more heavily discounted. When it comes to Comps, we’re looking outside a single company and comparing models to one another to get to a median valuation.

Other than rate hikes producing higher WACCs and lower forecasts, companies in a peer cohort may also suffer from macro events that drag forecasts and valuations down: labor costs, longer deal cycles, employee attrition, supply chain...

And when you smash a bunch of lower-ish models together, you usually get a lower-ish implied valuation. It’s contagious.

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Analogy: When you check your home’s estimated value on Zillow, it’s based on what similar homes in your neighborhood recently sold for.

Why It Matters: In today’s market, company’s aren’t raising as much cash. This means they have less to spend on M&A, which means companies end up selling for less. The price of debt financing went up too.

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