5F.6
6. You are in charge of coming-up with a value for a private company that will be going public soon. The company, Wegman's, is a large regional grocery store chain. You look-up the price-to-cash flow ratio for two other regional grocery store chains and find that Albertson's is 12.2 and Safeway's is 12.1. This year's cash flow for Wegman's is $1 billion.
a. What's your best guess for what Wegman's is worth? [5]
This is an application of multiples. The P/CF ratios are telling you that Albertson's and Safeway are worth about 12 times their current year cash flows. You could use the average of Albertson's and Safeway's P/CF ratios (12.15) and multiply it by $1B to get $12.15B.
b. What assumptions are you making in coming-up with that value? [6]
The most important assumption going into this valuation is that Wegman's is similar enough to Albertson's and Safeway to use their multiples. For example, if Albertson's or Safeway are expected to grow by more than Wegman's is, then these multiples are too high. Conversely, if for some reason, Wegman's is expected to grow by more than these multiples are too low. Even if the growth assumptions are met, if this year's cash flows are unusual for any of the three companies, then the comparison may not work. For example, if Wegman's cash flows were temporarily much higher than usual, then it would be inappropriate to apply the P/CF multiple to the total cash flow measure rather than the underlying cash flows not due to temporary shocks.