First Chicago method: Difference between revisions

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The '''First Chicago Method''' or '''Venture Capital Method''' is a context specific [[business valuation]] approach used by [[venture capital]] and [[private equity]] investors that combines elements of both a [[Valuation using multiples|multiples-based valuation]] and a [[discounted cash flow]] (DCF) valuation approach.<ref>[http://research.kauffman.org/cwp/appmanager/research/researchDesktop;jsessionid=IaIkfkTdY4dXKNiCWdGg61LY3d2P2Ke79urHnyuu4spdtbYuPfvo!484687239?_nfpb=true&_pageLabel=research_resourceDetail&keep=all&id=1133004&_nfls=false Kauffman Foundation article on The First Chicago Method]. [[Kauffman Foundation]].</ref>

Rather than completing a valuation of the company, the First Chicago Method takes account of payouts to the holder of specific investments in a company through the holding period under various scenarios.; see [[Corporate_finance#Quantifying_uncertainty| Corporate finance: Quantifying uncertainty]]. Most often this methodology will involve the construction of:

* An "upside case" or "best case scenario" (often, the [[business plan]] submitted)

* A "base case"

* 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]]. Next, a divestment price - i.e. [[Terminal value]] - is modelled by assuming an [[Terminal_value_(finance)#Exit_Multiple_Approach |exit multiple]] consistent with the scenario in question. (Of course, the divestment may take various forms - see [[Private_equity#Investments_in_private_equity| Private equity: Investments in private equity]].) 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 [[Weighted mean|probability weighted sum]] of the three scenarios.

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.