Valuation and Investment

Banking
Unit – 4
CASH FLOW APPROACH TO VALUATION
By
PREMALATHA K P
 VALUATION METHODS

STOCK AND DISCOUNTED

BOOK VALUE
DEBT CASH FLOW
APPROACH
APPROACH APPROACH

RELATIVE OPTION
VALUATION VALUATION
APPROACH APPROACH
 STOCK AND DEBT APPROACH

• When the securities of a firm are publicly traded its value can be obtained by
merely adding the market value of all its outstanding securities.
• Also called as market approach
• Assumes market efficiency.
• Ex – on march 31, 2021 the firm had 1.5 billion o/s shares. At the closing price of 20th on that day,
Horizon’s equity had a market value of 21 billion. On march 31, 2021 the frim also had o/s debt
with market value of 21 billion.
• Therefore total value of the firm = (21 +21)
 Direct comparison approach / Relative valuation
approach
• The Direct Comparison Approach is based on the premise of
the "Principle of Substitution" which implies that a rational
investor or purchaser will pay no more for a particular property
than the cost of acquiring another similar property with the
same utility.
• One can value an asset by looking at the price at which a
comparable asset has changed hands between a reasonable
informed buyer and a reasonable informed seller.
Two kinds of multiples used in relative valuation:
1. Enterprise multiples
Expresses the value of the company enterprise value, in relation to a
statistic that applies to the whole company.
EV / EBITDA, EV/BV, EV/S
2. Equity multiples
Expresses the value of equity in relation to an equity statistic.
P/E, P/BV
P = market price per share, BV = book value, E = earnings per share.
Discounted cash flow approach
• Discounted cash flow (DCF) refers to a valuation method that
estimates the value of an investment using its expected
future cash flows.
• The present value of expected future cash flows is arrived at by
using a projected discount rate.
• A disadvantage of DCF is its reliance on estimations of future
cash flows, which could prove inaccurate.
Basic terminologies
• FCFF, or Free Cash Flow to Firm, is the cash flow available to
all funding providers (debt holders, preferred stockholders,
common stockholders, convertible bond investors, etc.).
• FCFE, or “free cash flow to equity”, measures the amount of
cash remaining for equity holders once operating expenses, re-
investments, and financing-related outflows have been
accounted for.
• Levered and unlevered
Models of DCF valuation
1. Enterprise DCF model - calculates FCFF (free cash flow to
the firm)
2. Equity DCF model – two variants - DDM and FCFE (free
cash flow to equity)
3. Adjusted present value model – two components- value of
the unlevered equity free cash flow + value of the financing
side effects
4. Economic profit model – two components
current invested capital + PV of the future economic profit
stream.
Enterprise DCF Model
• Valuing a firm using the discounted cash flow approach for
forecasting cash flows over an indefinite period of time for an
entity that is expected to grow.
• The value of the firm is separated into two time periods:
value of the firm =
(present value of cash flow during an explicit forecast period) +
(present value of cash flow after the explicit forecast period).
Steps for valuing a firm – DCF approach
1. Analysing historical performance
2. Estimating the cost of capital
3. Forecasting performance
4. Determining the continuing value
5. Calculating the firm value and interpreting the results.
2 – Stage growth models
• Allows for two stages of growth – an initial period of higher
growth followed by a stable (but lower) growth forever.

Value of the firm = PV of the FCF during the high growth phase +
present value of terminal value.
3 stage growth model
• Assumes that:
• The firm will enjoy a high growth rate for a certain period(3-7 yrs)
• The high growth period will be followed by a transition period during
which the growth rate will decline in the linear increments.
• The transition period will be followed by a stable growth rate forever.
• Value of the firm =
PV of FCF during high growth period + PV of FCF during transition
period + PV of terminal value.