Valuation

Models
Module 5
 Introduction to Valuation Models

Discounted Cash Flow Valuation

Topics
Relative Valuation

Free Cash Flow Valuation

Introduction
• Valuation of a company is associated with a lot of difficulties and
insecurities. It is impossible to estimate the object value of a
company only by counting, since the numbers are not the only factor
to consider. To facilitate the business valuation process there are a
number of helpful models. According to theory the business valuation
procedure should consist of several phases to provide a reliable value.
These phases are business analysis, accounting and financial analysis,
forecasting and valuation itself.

• The valuation models commonly described may be classified as

follows:
• (I) Asset-based approach
• (II) Income-based approach
• (III) Market-based approach
 • The asset-based approach is also known as the asset accumulation
method, the net asset value method, the adjusted book value method
or the asset build-up method.
• The purpose of the model is to study and revaluate the company’s
assets and liabilities obtaining the substance value which also is the

Asset-based
equity. The substance value is thus estimated as assets minus
liabilities
• To be useful, the substance value must be positive, if liabilities are
Approach bigger than assets there is no use of the method.
• Two methods are used here:
• (a) The Liquidation Value, which is the sum as estimated sale values
of the assets owned by a company.
• (b) Replacement Cost: The current cost of replacing all the assets of a
company.
 • The income approach is commonly called Discounted Cash Flow
(DCF).
• It is accepted as an appropriate method by business appraisers. This
approach constitutes estimation of the business value by calculating
the present value of all the future benefit flows which the company

Income-based
are expected to generate.
• Mathematically it can be expressed as the following formula:

Approach

• There are several models of income approach depending on which

type of income flows that will be discounted. The common benefit
flows that are usually used in the income-based approach are
dividends, free cash flows and residual income.
Market-based • The market approach determines company value by comparing one or

Approach
more aspects of the subject company to the similar aspects of other
companies which have an established market value.
• The market approach excels in situations where abundant data is
available on comparable transactions. When that data is not available,
alternative approaches may be required.
Different Valuation Models
• (1) Discounted cash flow valuation : It relates to the value of an
asset to the present value of expected future cash flows on that
asset.
• (2) Relative valuation : It estimates the value of an asset by
looking at the pricing of ‘comparable’ assets relative to a
common variable such as earnings, cash flows, book value or
sales. The profit multiples used are (a) Earnings before interest,
tax, depreciation and amortisation (EBITDA), (b)Earning
before interest and tax (EBIT), (c) Profits before tax (PBT) and
(d) Profit after tax (PAT).
• (3) Contingent Claim valuation : It uses option pricing models
to measure the value of assets that have share option
characteristics. Some of these assets are traded financial assets
like warrants, and some of these options are not traded and are
based on real assets. Projects, patents and oil reserves are
examples. The latter are often called real options.
Discounted Cash flow (DCF) Valuation
• DCF method is an easy method of valuation. To understand and evaluate the other two methods of
valuation it is important to understand the DCF method first.
• Discounted cash flow DCF analysis determines the present value of a company or asset based on the
value of money it can make in the future. To use discounted cash flow valuation, you need
• to estimate the life of the asset
• to estimate the cash flows during the life of the asset
• to estimate the discount rate to apply to these cash flows to get present value

• The DCF model estimates a company’s intrinsic value (value based on a company’s ability to
generate cash flows) and is often presented in comparison to the company’s market value.
Inputs to Discounted Cash Flow Models
• There are three inputs that are required to value any asset in this model - the expected cash flow, the
timing of the cash flow and the discount rate that is appropriate given the riskiness of these cash
flows.
(a) Discount Rates
• In valuation, we begin with the fundamental notion that the discount rate used on a cash flow should
reflect its riskiness. In case of higher risk, cash flows to be discounted with higher discount rates.
(b) Expected Cash Flows
• In the strictest sense, the only cash flow an equity investor gets out of a publicly traded firm is the
dividend; models that use the dividends as cash flows are called dividend discount models.
(c) Expected Growth
• While estimating the expected growth in cash flows in the future, analysts confront with uncertainty
most directly. There are many ways of estimating growth. One is to look at a company’s past and
use the historical growth rate posted by that company. The peril is that past growth may provide
little indication of future growth.
Pros of a DCF model
It would be best for a financial analyst to use the DCF analysis if they are confident about the assumptions
being made. A discounted cash flow model requires a lot of detail to make an estimate of the intrinsic value of
a stock, and each of those details requires an assumption.
The main Pros of a DCF model are:
• Extremely detailed
• Includes all major assumptions about the business
• Determines the “intrinsic” value of a business
• Does not require any comparable companies
• Can be performed in Excel
• Includes all future expectations about a business
• Suitable for analyzing mergers and acquisition
• Can be used to calculate the internal rate of return IRR of an investment
• Scenarios can be built-in
• Allows for sensitivity analysis
Cons of a DCF model
Despite the advantages of the DCF analysis, it is also exposed to some disadvantages. The main
drawback of DCF analysis is that it’s easily prone to errors, bad assumptions, and overconfidence in
knowing what a company is actually “worth”.
The main Cons of a DCF model are:
• Requires a large number of assumptions
• Prone to errors
• Prone to overcomplexity
• Very sensitive to changes in assumptions
• A high level of detail may result in overconfidence
• Looks at company valuation in isolation
• Doesn’t look at relative valuations of competitors
• Terminal value is hard to estimate and represents a large portion of the total value
• Challenging to estimate the Weighted Average Cost of Capital (WACC)
DCF Analysis of Apple
• Apple has a market capitalization of approximately $2.34 trillion USD.
Is that market price justified based on the company’s fundamentals and
expected future performance (i.e. its intrinsic value)? That is exactly
what the DCF seeks to answer.
Relative Valuation
• In relative valuation, the value of an asset is derived from the pricing of
‘comparable’ assets, standardized using a common variable. Included in this
description are two key components of relative valuation. The first is the notion of
comparable or similar assets. From a valuation standpoint, this would imply assets
with similar cash flows, risk and growth potential. In practice, it is usually taken to
mean other companies that are in the same business as the company being valued.
The other is a standardized price.

• Variations of Relative Valuation

• Direct Comparison
• Peer Group Average
Steps in Relative Valuation
• Search and select the comparable companies
• Selection of Multiples
• Selection of comparables and size of sample
• Computation of Multiples
• Apply and conclude
Valuation Multiples
Free Cash Flow Valuation
• Estimation of cash flows is an important step of a valuation process and the nature
of cash flows that would be used in the calculation would depend on the
perspective of the investor doing the analysis.
• Free cash flow concept focuses on the cash generated from operations in excess of
that needed for reinvestment. Analysts frequently value firms based on the present
value of expected future free cash flow. If a firm is not expected to generate free
cash flow in the future, it is unlikely to be valuable.
• Free cash flow valuation defines the value of the firm to be the present value of its
expected future cash flows discounted at the company’s cost of capital. Free cash
flow available to the firm (FCFF) represents cash flow available to both debt and
equity holders. Free cash flow to equity (FCFE) is what remains after debt holders
have received their contractually obligated payments namely interest
Free Cash Flow Valuation
• FCFF = NOP - Taxes - Net Investment - Net Change in Working Capital
Or
• FCFF = NI + Non Cash Charges + Interest (1-T) - Net Investment - Net Change in
Working Capital
• A positive value would indicate that the firm has cash left after expenses. A
negative value, on the other hand, would indicate that the firm has not generated
enough revenue to cover its costs and investment activities.
• FCFF can be calculated from the statement of cash flows as follows:
• FCFF=Cash Flow from operations + After-tax interest expense - Capital
expenditures