2022 First Chicago Valuation: What, Why, How, Examples, Advantages, Disadvantages
In today's world, startup valuations have become a major topic. With the recent surge in the popularity of new startups and the need for some cash to fund their growth, investors are being more selective about the companies they choose to back. For those on the outside looking in, however, it is hard to understand the dynamics that are involved with startup valuations. So, let's look at what factors influence them.
The valuation process should not only consider how valuable the company will be to its investors but also how successful it will be in providing value to different market players over time. When we're talking about a startup valuation, there's a lot of interest in the numbers. Let’s understand more about First Chicago Valuation Method.
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What is the First Chicago Valuation Method?
The First Chicago Method is a valuation technique that uses the discounted future cash flows of a company as its estimate of value. It is a linear-weighted capitalization-weighted market-value method. The valuation is done by estimating earnings, dividends, and the capital structure of the firm.
The First Chicago Valuation Method is a valuation method that focuses on three different scenarios, the best-case scenario, the base-case scenario, and the worst-case scenario.
Base Case: Performance meets expectations and is at the center of the bell curve.
Upside Case or Best Case: Performance exceeds expectations in the best-case scenario, with more than a 50% probability of occurrence, so it receives the highest weight attached to this case.
Downside Case or Worst Case: Performances fall below expectations in the worst case.
Once scenarios are assessed and weight values assigned to each of them, they are used to calculate the "Weighted Value" for the company.
It is a great tool for financial analysts as it provides an insight into what might happen if everything goes well if nothing goes well and if things are somewhere in between. These three scenarios give analysts a better idea of what could happen with their investments.
A key benefit of this valuation method is that it allows for quantitative evidence to be presented about risk compared to other valuation methods.
Formula to Calculate First Chicago Valuation
Where,
TV – Terminal Value
CF – Cash Flow
r – Discount Rate
t – Exit Time
i – Index of Scenario
Why First Chicago Valuation is Important?
The First Chicago Method can be used to estimate the value of all kinds of companies, regardless of industry. It is ideal for companies with stable cash flows and predictable growth that are not publicly traded, as well as privately held companies.
How To Perform First Chicago Valuation?
The First Chicago Method begins by estimating the free cash flow to equity over 10 years. This number is then discounted back to the present value using an appropriate interest rate (discount rate). An added step involves evaluating the terminal value or liquidation preference, which is usually calculated by looking at the average price-to-earnings for another company in the same industry and sector. A company's capital structure is estimated based on the number of shares outstanding, the percentage of shares held by insiders, and the percentage of shares held by institutional investors.
The First Chicago Method has three steps:
1) Estimate free cash flows to equity over 10 years for a firm.
2) Discount those cash flows back to present value using an appropriate interest rate.
3) Evaluate the terminal value or liquidation preference.
To use the method, a company must have a historical term to present a cash flow statement. This can be found in the notes section of its most recent 10-K report.
To understand more about DCF read our blog
Example of First Chicago Valuation
Let’s say we have a company whose DCF model is already completed each with a different set of assumptions.
The calculations under three different scenarios are as follows:
· Worst Case= 10M
· Base Case= 70M
· Best Case= 300M
The probability for each case is:
· Worst Case= 20%
· Base Case= 70%
· Best Case= 10%
Now Multiply the probability of each case with the value of the respective case and then add them up.
The weighted value of the company is:
=10x0.2 + 70x0.7 + 300x0.1
= 81M.
Advantages of First Chicago Valuation
This method is straightforward and transparent, which makes it easier to understand and forecast future values.
The value reflects the current regulatory environment for debt financing.
It is simple and easy to understand and is applied when no sale or purchase is imminent.
With the First Chicago Valuation Method, the analyst can assess and quantify the amount of risk that is present in a company’s balance sheet.
This method helps analysts to make educated decisions about their firms’ investments.
Disadvantages of First Chicago Valuation
It does not consider how different types and degrees of risk affect a company's market values and it does not account for fluctuations in dividend payout rates over time.
Its accuracy may be compromised if there are significant changes in the economy.
Conclusion
The first Chicago Valuation Method is a method for valuing a company using a discounted cash flow-based valuation. This method is more detailed in the assumptions and calculations, whereas most other methods only make simple assumptions. This may set off concerns regarding your understanding of the process, but it is not overly difficult to perform once understood properly.