Week 2 Flashcards
Why is valuation hard?
- future returns associated with assets are uncertain
- picking the right valuation method is hard
List of valuation models
Direct valuation
1. Dividend discount model
2. Operating cash flow model
3. Free cash flow model
Relative valuation
1. Peer group multiples
Myths about valuation
- Valuation models are quantitative and valuation is objective
- A well-researched and well-done valuation is timeless
- A good valuation provides precise estimates of value
- The more quantitative a model is, the better the valuation
- Valua is what matters, the price of valuations does not
Advantages and Disadvantages of dividend discount model
(+) it is an easy concepy
(+) dividend is fairly stable in the short run, which make them easy to forecast in the short run
(-) dividend payout will not be related to the value in the short run because firms focus on growth. DDM ignores change in the stock prices if it assumes constant dividend
(-) It requires a long forecast horizon
(-) what about the firms that do not pay dividend
When do we use DDM?
When it is tied to value generation, meaning when there is a fixed payout ratio (dividend/earnings)
The free cash flow model
A method that used to value a company, especially when evaluating firms that may not pay dividends or in a high growth phase
Advantages and Disadvantages of free cash flow model
(+) easy application of familiar present value techniques and real concept
(+) can accomodate a variety of different assumptions and scenerios
(+) more realistic than DDM as firms do not pay dividends
(-) free cash flow does not measure value added in the short run, and it is hard to forecast distant positive cash flow
(-) does not recongnize value without cash
(-) requires forecasts of the evolutions of many balance sheets items
Relative valuation
- identify comparable assets and obtain market values for these assets
- standardizing these market values (absolute prices cannot be compared)
- compare the standardized value or multiples of the asset with the standardized value of comparable assets, control for differents between firms that might affect the multiples
Understanding Multiples
Define multiples: The numerator (value) and denominator (standardizing variable) should reflect the same group of stakeholders
Describe the multiple: testing the distribution of multiples involves analyzing key statistical properties
Analyse the multiple: understanding the relationship between a fundamental (like growth) and a multiple (like P/E)
Apply the multiple: valuation theory suggests that a comparable firm is one which is similar to the one being analyzed in terms of fundamentals (or in the same industry according to traditional analysis)
Good and misuse of PE
(+) intuitively appealing statistic
(+) it is simple to compute for most stocks
(+) it is a proxy for other charateristics
(-) Using PE is a way for some analysts to avoid explicit assumption about risk, growth and payout ratios
(-) They are much more likely to reflect market moods and perception
Common approach to estimate PE
Choose a group of comparable firms, and to calculate average PE ratio for this group
Remember that you have to adjust this average difference between the firm being valued and comparable firms
Or regression method: PE ratio as depedent variable and proxies for risk, growth and payout ratio as the independent variables
Why is Value/EBIT so popular
- The multiples can be computed if there is net loss
- For firms which requires substantial investment and long gestation period, it is more appropriate than PE
- By looking at cash flow prior to capital expenditure, it reflects better estimate of optimal value
- By looking at value (inclusive of debt) and cash flow to the firm (prior to debt payments) allowing comparison across firms
Which models to use?
Underwriters are relying on DDM to value IPO stocks
Early stage VCs are likely to use exit multiples while late stage VCs are likely to use FCF
FFC vs DDM
FFC represents maximumm dividend a firm can pay after covering operational and capital expenses
It has a broader measure, capturing value beyong dividends
