Approaches to valuation Discounted cash flow (DCF) valuation

1. Valuation plays a key role in many areas of finance: in corporate finance, mergers and acquisitions, and in portfolio management. Palepu and Healy, 2008: “For the professional analyst, the final product of the work, is of course, a forecast of the firm’s future earnings and cash flows, and an estimate of the firm’s value. But that final product is less important than the understanding of the business and its industry, which the analysis provides. It is such understanding that positions the analyst to interpret new information as it arrives and infer its implications.”

2. Approaches to valuation Discounted cash flow (DCF) valuation • In DCF valuation, we try to estimate the intrinsic value of an asset based on its fundamentals. • The general form of any DCF valuation (this can be used to value any asset) is • A key point to remember is that the discount rate has to reflect the relative riskiness of the cash flows

3. Categories of DCF • Equity Valuation • this approach values just the equity stake in the business (where ke is the cost of equity) And the free cash flows to equity is calculated by: • the dividend discount model is a specialized case of equity valuation

4. Firm Valuation • This approach values the entire firm (i.e., claims by equity holders, bond holders, and preferred shareholders) And the free cash flows to equity is calculated by: • Adjusted Present Value Valuation • This approach values each claim on the firm separately Value of firm = Value of all-equity financed firm + PV of tax benefits + Expected bankruptcy costs

5. Limitations of DCF • Firms in trouble • Cyclical firms • Firms with unutilized assets • Firms with patents or product options • Firms in the process of restructuring • Firms involved in acquisitions • Private firms • In each of these cases, we may need to make adjustments to DCF valuation

6. Relative Valuation • The value of an asset is derived from the pricing of comparable assets, standardized using a common variable such as earnings, cash flows, book value, or revenues • Unlike DCF valuation, which is a search for intrinsic value, relative valuation relies much more on the market. That is, we assume that the market is correct in the way it prices stocks, on average, but that it makes errors on the pricing of individual stocks. • Categories of relative valuation • Fundamentals vs. comparables • Cross-sectional vs. time-series • Limitations • Difficult to value unique firms • Easy to misuse and manipulate

7. Contingent Claim Valuation • In contingent claim valuation, we recognize that the value of an asset may be greater than the present value of expected cash flows if the cash flows are contingent on the occurrence or non-occurrence of an event. • Categories of contingent claim valuation • Financial asset or real asset • Traded underlying asset. Options on nontraded assets are much more difficult to value since there are no market inputs available on the underlying assets Asset-based valuation • We estimate what the assets owned by a firm are currently worth • Two approaches • Liquidation value • Replacement cost

9. Sources: • Damodaran, Investment Valuation, 2nd ed.