First Chicago method: Difference between revisions

Revision as of 09:03, 31 May 2012

Revision as of 09:05, 31 May 2012

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* A "downside" or "worst case scenario"

The [[valuation]] proceeds as follows. First, for each case, a [[Scenario_planning |scenario specific]], ''internally consistent'' forecast of [[cashflow]]s is constructed for the years leading up to the assumed [[Divestment#Divestment_for_financial_goals |divestment]] by the private equity investor; see[[Corporate_finance#Quantifying_uncertainty| Corporate finance: Quantifying uncertainty]]; [[Financial_modeling#Accounting| Financial modeling: Accounting]]. (whichThe divestment may take various forms; - see [[Private_equity#Investments_in_private_equity| Private equity: Investments in private equity]]). Next, a divestment price is modelled by assuming an [[Terminal_value_(finance)#Exit_Multiple_Approach |exit multiple]] consistent with the scenario in question (see [[Terminal value]]). The cash flows and exit price are then [[present value|discounted]] using the investor’s [[Required rate of return|required return]], and the sum of these is the value of the business under the scenario in question. Finally, the three values are multiplied through by a [[probability]] corresponding to each scenario (as estimated by the investor). The value of the investment is then the probability weighted sum of the three scenarios. See also [[Corporate_finance#Quantifying_uncertainty| Corporate finance: Quantifying uncertainty]]; [[Financial_modeling#Accounting| Financial modeling: Accounting]].

The method is used particularly in the valuation of [[growth company|growth companies]] which often do not have historical financial results that can be used for meaningful [[comparable company analysis]]. Multiplying actual financial results against a comparable valuation multiple often yields a value for the company that is objectively too low given the prospects for the business.