Why can’t you use EV/Earnings or Price/EBITDA as valuation metrics?

Enterprise Value (EV) equals the value of the operations of the company attributable to all providers of capital.  That is to say, because EV incorporates all of both debt and equity, it is NOT dependant on the choice of capital structure (i.e. the percentage of debt and equity).  If we use EV in the numerator of our valuation metric, to be consistent (apples to apples) we must use an operating or capital structure neutral (unlevered) metric in the denominator, such as Sales, EBIT or EBITDA.  These such metrics are also not dependant on capital structure because they do not include interest expense.  Operating metrics such as earnings do include interest and so are considered leveraged or capital structure dependant metrics.  Therefore EV/Earnings is an apples to oranges comparison and is considered inconsistent.  Similarly Price/EBITDA is inconsistent because Price (or equity value) is dependant on capital structure (levered) while EBITDA is unlevered.  Again, apples to oranges.  Price/Earnings is fine (apples to apples) because they are both levered.

How do you use the three main valuation methodologies to conclude value?

The best way to answer this question is to say that you calculate a valuation range for each of the three methodologies and then “triangulate” the three ranges to conclude a valuation range for the company or asset being valued.  You may also put more weight on one or two of the methodologies if you think that they give you a more accurate valuation.  For example, if you have good comps and good precedent transactions but have little faith in your projections, then you will likely rely more on the Comparable Company and Precedent Transaction analyses than on your DCF.

Of the three main valuation methodologies, which ones are likely to result in higher/lower value?

Firstly, the Precedent Transactions methodology is likely to give a higher valuation than the Comparable Company methodology.  This is because when companies are purchased, the target’s shareholders are typically paid a price that is higher than the target’s current stock price.  Technically speaking, the purchase price includes a “control premium.” Valuing companies based on M&A transactions (a control based valuation methodology) will include this control premium and therefore likely result in a higher valuation than a public market valuation (minority interest based valuation methodology).

The Discounted Cash Flow (DCF) analysis will also likely result in a higher valuation than the Comparable Company analysis because DCF is also a control based methodology and because most projections tend to be pretty optimistic.  Whether DCF will be higher than Precedent Transactions is debatable but is fair to say that DCF valuations tend to be more variable because the DCF is so sensitive to a multitude of inputs or assumptions.