First Chicago Valuation Method - Explained
What is the First Chicago Method?
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What is the First Chicago Method of Business Valuation
The First Chicago Method is a hybrid approach that employs multiples to derive a terminal value and discounts future cash flows to arrive at a present valuation. Notable about this method is that it requires three projections based upon company performance.
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A best case scenario is based upon company performance that exceeds most expectations. That is, a best scenario is what the majority believes to be the future performance of the firm.
Finally, a downside or worst case scenario projects company performance if many contingencies go wrong. The method begins by projecting future cash flows of the firm in the above three scenarios.
As with any future projection, future cash flows are very speculative. Allowing for the three scenarios allows for the risk associated with each scenario. The cash flows continue until an anticipated exit event for the firm. This is generally between three and seven years for most firms. Then the firm uses the final years cash flows comparable multiple to project a terminal valuation for each scenario.
The comparable multiple is derived from the methods previously discussed. The prospective investor will then discount each years cash flows and the terminal value based upon the investors required rate of return. For the terminal value, this will involve identifying a required multiple that produces an acceptable annual rate of return. For the cash flows, the required rate of return will be used to discount the value of each years cash flow.
At this point, the investor has six present value calculations (i.e., a multiples and discounted cash flow calculation for each performance scenario). The investor will now multiple each of these valuations by an anticipated probability of occurrence.
All the probabilities together should add up to one or one-hundred percent. The resulting amounts are then tallied to arrive at a single present valuation for the firm. This weighted-average valuation takes into account the risks inherent in company operations and reduces the effect of inadequacies in any single valuation method.
The First Chicago method has emerged as an industry leader among venture capital and private equity firms.
Early stage investors, however, have not fully adopted this approach. As with all income-based approaches, the projection of revenues for an early-stage venture is too speculative to be of value to these investors.
As such, the early-stage investor generally employs the venture capital method, along with any secondary asset-based approaches.