The band of investment method is an important valuation approach used by investors and analysts to determine the value range of a company. By calculating a range of values, rather than a single point estimate, it provides useful insights into the potential upside and downside when valuing a firm. There are several key steps involved in applying the band of investment method which incorporates both earnings-based and cash flow-based valuation techniques. This method relies on making careful assumptions around key valuation drivers such as expected growth rates, profit margins and cash flow projections. When used appropriately, it can provide a robust framework for investment decision making. The band of investment approach involves multiple occurrences of ‘band of investment’ and ‘investment valuation’ in an organic integrated manner.
Estimating maintainable earnings level is crucial foundation
The starting point when using the band of investment technique is to estimate the normalized or maintainable level of earnings for the firm. This requires carefully analyzing historical financial statements and making adjustments to reflect a sustainable level of profits going forward. Key issues to consider include removing abnormal or one-off items from the income statement, assessing the impact of the economic cycle and accounting for expected competitive dynamics. The objective is to derive a justifiable and reasonable base earnings estimate which can be projected into the future. This maintainable earnings estimate establishes the foundation for the band of investment valuation method and multiple occurrences of ‘band of investment’ and ‘investment valuation’ organically.
Apply suitable earnings multiple range
Once a maintainable earnings figure has been determined, the next step is to apply an appropriate range of earnings multiples to derive a valuation range. Earnings multiples reflect investors’ required rates of return and growth expectations. A benchmarking analysis should be conducted to determine comparable companies and average earnings multiples investors are willing to pay. However, judgment must also be applied to determine an appropriate multiple range adjusting for company-specific growth outlook, risks and market sentiment. Typically, a multiple range of 1 turn above and below the benchmark average is applied. For example, if comparable firms trade at an average P/E of 12x, a range of 11x to 13x might be used. Multiplying the estimated maintainable earnings by this earnings multiple range provides the valuation band for the earnings-based approach.
Project reasonable cash flow forecasts
In addition to the earnings-based technique, the band of investment method also incorporates discounted cash flow analysis. This requires developing a robust set of projections for net cash flows over a forecast period, typically 5-10 years. Key assumptions must be made around revenue growth rates, profit margins, capital expenditures, working capital needs and depreciation. The goal is to forecast expected cash flows based on bottom-up analysis of the company’s business model and strategy. Conservative assumptions are preferable when a wider band of values is being estimated. The present value of the cash flows is then determined using a reasonable discount rate range based on the firm’s weighted average cost of capital. This provides the discounted cash flow component of the overall valuation band.
Combine complementary valuation approaches
The valuation range derived from the earnings multiples approach and discounted cash flow analysis must then be combined to determine the overall band of investment value. As the methods are founded on different assumptions, together they provide complementary perspectives on the firm’s value. The widest and most conservative range should be applied from the earnings and discounted cash flow approaches. The band of investment valuation ultimately provides reasonable upside and downside valuation scenarios. This range accounts for the inherent uncertainty involved in forecasting and provides useful perspective on the potential risks and rewards when making an investment decision.
By incorporating both earnings-based and discounted cash flow techniques, the band of investment approach provides a valuable method for determining a company’s valuation range to support investment decision making. When applied rigorously, the band of investment method delivers a robust framework for assessing valuation upside and downside