Valuation of firms is encountered in different situations like Mergers & Acquisitions, Leveraged Buy-outs (LBOs & MBOs), IPOs etc.
There are two common valuation approaches, the discounted cash flow (DCF) valuation method and the relative valuation method, also known as multiples. Although they are both generally applied tools for effective investment decision making, they differ in the way they estimate the value of an asset.
a. Discounted Cash Flow (DCF) Valuation
DCF valuation is based on the assumption that the value of an asset equals the present value of the expected cash flows on the asset. To do DCF valuation, analysts calculate the present value of the expected future cash flows and discount it by the cost of risk incurred by the cash flows and the life of the asset.
This valuation is based on two basic principles:
Every asset has an intrinsic value that can be projected if cash flows, growth and risk are known.
Markets are inefficient and assets are not priced perfectly, but they can correct themselves when new information about the asset becomes available.
The inputs for DCF valuation are the discount rate, the cash flows and the growth rate. DCF valuation can be used both for valuing equities and firms
When valuing equity, analysts use the cost of equity as a discount rate, cash flows to equity (CF to Equity) and growth in equity earnings. When valuing a firm, analysts use the cost of capital as a discount rate, cash flows to firm (CF to Firm) and growth in operating income.
In both cases, growth is used to calculate the expected cash flows. Also, the discount rate can be in nominal or real terms.
Advantage:
By taking into consideration the intrinsic value of the asset, investors are aware of the und...
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... for wrong judgment between overvalued and undervalued securities. Even if a security is found overvalued with relative valuation, it may still be undervalued compared to the market. This happens because relative valuation assumes that although markets are inefficient, errors in pricing can be identified and corrected more easily. However, this applies for the markets in the aggregate and not for individual securities.
The relative valuation requires fewer inputs than DCF valuation implies that for any other variable the model makes implicit assumptions, which if proved wrong, the entire model is wrong.
In conclusion, there is no better or worse valuation model. Both DCF valuation and relative valuation serve their purposes effectively. The choice between the two is subject to the valuation philosophy, the time horizon and the individual beliefs about the market.
Earlier 2002, the stock price of Agnico-Eagle Mines sharply decreased by $1 finally closed at $13.89. This price has reached one of the lowest level, from the company's historical perspective. As a professional equity portfolio manager, who has a large number of AEM stocks on hand. Acker and his team are necessary to find a proper way to estimated the fair value of AEM as well as its equity. Discounted Cash Flow (DCF) has been chosen to do this job. The theory behind DCF valuation approach is that the firm's value can be estimated by using the expected future free cash flow discounted by an appropriate discounted rate (Koller etc 2005). However several assumptions need to be clearly examined within this approach. The following sections are showing the process of DCF step by step.
... value, however, depreciation affects such values as operating profit and value of the company’s assets. If the depreciation is ignored, the Net Income calculations will be erroneous.
This object is one of the financial goals to invest properly. Marriott used discounted cash flow techniques to evaluate potential investment. It is beneficial because it is considered present time value. Projects which increase shareholder value could be formed with benchmark hurdle rates, the company can ensure a return on projects which results in profitable and competitive advantage.
Using P/E multiple method is suitable for evaluation the company stock, however this mothed does not do the same quality as DCF model, when we differentiate between other companies. Even though, it does not give the exact outcomes when we have more companies in the same field. Dividend growth model is not relevant to this company because the company did not reveal its dividend in the stock market. Also, the company wish for its earing to fund its growth. Thus, it is hard to use this method because we don’t have any information about the dividend. Since the DCF model is more appropriate to use, it also give us the best image to the relative companies in intrinsic stock value.
(CAPM). Other methods, such as the dividend-discount model (DDM) and the earnings-capitalization ratio, can be used to estimate the cost of equity. In my opinion, however, the CAPM is the superior method.
2. Given the forecasts provided in the case, estimate the expected incremental free cash flows associated with Du Pont’s growth strategy and maintain strategy for the TiO2 market. How much risk and uncertainty surround these future cash flows? Which strategy looks most attractive (i.e., using the DCF (e.g., NPV) method)??
Discounted cash flow is a valuation technique that discounts projected cash inflows and outflows to evaluate the potential value of an investment. There are three discounted cash flow methods: Net Present Value (NPV), Profitability Index (PI) and Internal Rate of Return (IRR). The net present value discounts all cash inflows and outflows at a minimum rate of return, which is usually the cost of capital. The profitability index refers to the ratio of the present value of cash inflow to the present value of cash outflows. The internal rate of return refers to the interest rate that discounts cash inflow projections to the present to ensure that the present value of cash inflows is equivalent to the present value of cash outflows (Brown, 1992).
When discussing the cost of equity capital, or the rate of return required by investors for their share expenses, there are three main models widely used for analyzation. These models are the dividend growth model, which operates on the variable of growth and future trends, the capital asset pricing model (CAPM), which operates on the premise that higher returns are a result of higher risk, and the arbitrage pricing theory (APT), which has a more flexible set of criteria than CAPM and takes advantage of mispriced securities
Arcading to Michael Hollihan (1982) Relative price are supposed to reflect real forces such as changes in tastes and technology, while the changes in the aggregate price level would reflect monetary changes since price is
Present theoretical arguments for the choice of net present value as the best method of investment appraisal;
Xiong, J. X., Ibbotson, R. G., Idzorek, T. M., & Chen, P. (2010). The Equal Importance of Asset
Bond valuation is a technique which is used to determine the fair value of a particular bond. Bond valuation includes calculating the present value of the bond's future interest payments, also known as its cash flow, and the bond's value upon maturity, also known as its face value or par value.
Obviously, this case aims to evaluate Joanna’s analysis. Throughout the analysis, we will estimate the cost of debt, cost of equity, and cost of capital through different financial analysis models.
When compared to the physical capital maintenance concept, the financial capital maintenance concept is the better choice for standard setting when distinguishing between a return of capital and a return on capital. The main argument in favor of physical capital maintenance is that it provides information that has better predictive value, confirmatory value, and is more complete. However, due to agency theory, prospect theory, and positive accounting theory, neutrality and completeness under physical capital maintenance would be impaired so gravely that predictive value and confirmatory value become inefficacious. As a result, financial capital maintenance, with its use of historical cost, is able to provide information to decision makers with stronger confirmatory value and predictive value.
During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first task is to estimate Harry Davis’s cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task.