Methods of Valuation

3 Approaches to Valuation
• Intrinsic valuation: The value of an asset is a function of its fundamentals –cash flows, growth
and risk. In general, discounted cash flow models are used to estimate intrinsic value.

• Relative valuation: The value of an asset is estimated based upon what investors are paying
for similar assets. In general, this takes the form of value or price multiples and comparing
firms within the same business.

• Contingent claim valuation: When the cash flows on an asset are contingent on an external
event, the value can be estimated using option pricing models.
 Discounted Cash Flow Model

• Using Dividend Discount Model

• Using Free Cash Flows to Equity
• Using Free Cash Flows to Firm
 Valuation Using Multiples
The process consists of:
• identifying comparable assets (the peer group) and obtaining market values for these
assets.
• converting these market values into standardized values relative to a key statistic,
since the absolute prices cannot be compared. This process of standardizing
creates valuation multiples.
• applying the valuation multiple to the key statistic of the asset being valued,
controlling for any differences between asset and the peer group that might affect the
multiple.
• A valuation multiple is simply an expression of market value of an asset relative to a key statistic that is assumed to relate
to that value. To be useful, that statistic – whether earnings, cash flow or some other measure – must bear a logical
relationship to the market value observed; to be seen, in fact, as the driver of that market value.
• A peer group is a set of companies or assets which are selected as being sufficiently comparable to the company or assets
being valued (usually by virtue of being in the same industry or by having similar characteristics in terms of earnings
growth and/or return on investment).
• In practice, no two businesses are alike, and analysts will often make adjustment to the observed multiples in order to
attempt to harmonize the data into more comparable format. These adjustments may be based on a number of factors,
including:
a) Industrial / business environment factors: Business model, industry, geography, seasonality, inflation
b) Accounting factors: Accounting policies, financial year end
c) Financial: Capital structure
d) Empirical factors: Size
 Commonly Used Types of Multiples
• Equity Based Multiples –
a) P/E Ratio
b) Price/Cash Earnings
c) Price/Book Ratio
d) Dividend Yield
• Enterprise Value Based Multiples -
a) EV/Sales
b) EV/EBITDA
c) EV/Enterprise FCF
 Advantages
• Despite these disadvantages, multiples have several advantages.
a) Usefulness: Valuation is about judgment, and multiples provide a framework for making value judgments.
When used properly, multiples are robust tools that can provide useful information about relative value.
b) Simplicity: Their very simplicity and ease of calculation makes multiples an appealing and user-friendly
method of assessing value. Multiples can help the user avoid the potentially misleading precision of other,
more ‘precise’ approaches such as discounted cash flow valuation or EVA, which can create a false sense
of comfort.
c) Relevance: Multiples focus on the key statistics that other investors use. Since investors in aggregate move
markets, the most commonly used statistics and multiples will have the most impact.
d) These factors, and the existence of wide-ranging comparables, help explain the enduring use of multiples
by investors despite the rise of other methods.
 Disadvantages
• There are a number of criticisms levied against multiples, but in the main these can
be summarised as:
• Simplistic: A multiple is a distillation of a great deal of information into a single
number or series of numbers. By combining many value drivers into a point estimate,
multiples may make it difficult to disaggregate the effect of different drivers, such as
growth, on value. The danger is that this encourages simplistic – and possibly
erroneous – interpretation.
• Static: A multiple represents a snapshot of where a firm is at a point in time, but fails
to capture the dynamic and ever-evolving nature of business and competition.
• Difficulties in comparisons: Multiples are primarily used to make comparisons of relative value. But
comparing multiples is an exacting art form, because there are so many reasons that multiples can differ,
not all of which relate to true differences in value. For example, different accounting policies can result in
diverging multiples for otherwise identical operating businesses.
• Dependence on correctly valued peers: The use of multiples only reveals patterns in relative values, not
absolute values such as those obtained from discounted cash flow valuations. If the peer group as a whole is
incorrectly valued (such as may happen during a stock market "bubble") then the resulting multiples will
also be misvalued.
• Short-term: Multiples are based on historic data or near-term forecasts. Valuations base on multiples will
therefore fail to capture differences in projected performance over the longer term, and will have difficulty
correctly valuing cyclical industries unless somewhat subjective normalization adjustements are made.
Scenario Analysis
 What is Scenario Analysis ?

In scenario analysis, we estimate expected cash flows and asset value under various
scenarios, with the intent of getting a better sense of the effect of risk on value.

Scenario Analysis is a process to ascertain and analyse possible events that can take
place in the future. This is an important tool in the world of finance and economics,
and is used extensively to make projections for the future. 
 Steps In Scenario Analysis

Step 1 : Determination Of Factors/Variables.

Step 2: Number Of Scenarios for Each factor.

Step 3: Estimation of Asset Cash Flows Under Each Scenario.

Step 4: Assignment of Probabilities to Each Scenario.

 STEP 1
• The first is the determination of which factors the scenarios will be
built around.
• These factors can range from the state of the economy for an automobile
firm considering a new plant, to the response of competitors for a
consumer product firm introducing a new product, to the behavior of
regulatory authorities for a phone company, considering a new phone
service.
 STEP 2
• The second component is determining the number of scenarios to
analyze for each factor. While more scenarios may be more realistic than
fewer, it becomes more difficult to collect information and differentiate
between the scenarios in terms of asset cash flows. Thus, estimating cash
flows under each scenario will be easier if the firm lays out five scenarios,
for instance, than if it lays out 15 scenarios.
• The question of how many scenarios to consider will depend then upon
how different the scenarios are, and how well the analyst can forecast cash
flows under each scenario.
 STEP 3
• The third component is the estimation of asset cash flows under each
scenario.
 STEP 4
• The final component is the assignment of probabilities to each scenario.
• For some scenarios, involving macro-economic factors such as exchange
rates, interest rates and overall economic growth, we can draw on the
expertise of services that forecast these variables.
• For other scenarios, involving either the sector or competitors, we have to
draw on our knowledge about the industry.
Value Enhancement: Tools
and Techniques
 The Paths to Value Creation
Using the DCF framework, there are four basic ways in which the value of a firm can be enhanced:-
1.The cash flows from existing assets to the firm can be increased, by either
 Increasing after-tax earnings from assets in place or
 Reducing reinvestment needs (net capital expenditures or working capital)
2.The expected growth rate in these cash flows can be increased by either
 Increasing the rate of reinvestment in the firm
 Improving the return on capital on those reinvestments
3.The length of the high growth period can be extended to allow for more years of high growth.
4.The cost of capital can be reduced by :-
 Reducing the operating risk in investments/assets
 Changing the financial mix
 Changing the financing composition
Path 1: Increase Cash Flows from Assets in Place
Path 2: Increase Expected Growth
Path 3 :Building Competitive Advantages: Increase length of the
growth period
Path 4 :Reduce Cost of Capital