Question

Problem #1
An analyst tells you that he uses price/earnings multiples, rather than discounted cash flow valuation, to value stocks, because he does not link making assumptions about fundamental -growth, risk, and payout ratios. Is his reasoning correct?

Problem #2
Why might discounted cash flow valuation be difficult to do for the following types of firms?
A. So private firm, where the owner is planning to sell the firm.
B. A biotechnology firm, with no current products or sales, but with several promising product parents in the pipeline.
C. A cyclical firm, during a recession.
D. A troubled firm, which has made significant losses and is not expected to get out of trouble for a few years.
E. A firm, which is in the process of restructuring, where it is selling some of its assets and changing its financial mix.
F. A firm, which owns a lot of valuable land that is currently unutilized.

Answer 1

Problem #1
An analyst tells you that he uses price/earnings multiples, rather than discounted cash flow valuation, to value stocks, because he does not link making assumptions about fundamental -growth, risk, and payout ratios. Is his reasoning correct?

Ans.

No. The valuation model to be used vary from case to case basis. DCF method is to be used when future cash flows can be reasonable forecasted based on past trends or the industry growth rate. Whereas, PE multiple is to be used when there is no certainty about the future CF’s from that particular business, expected rate of return is not expressive based on current market scenario or the Company belong to the sector whereby the direction are decided for industry as a whole.

Problem #2
Why might discounted cash flow valuation be difficult to do for the following types of firms?
Ans. DCF requires 3 things i.e. Future cashflows, growth rate expected, Required rate of return.

Below mentioned question are to be judged based on these three factors.

A. So private firm, where the owner is planning to sell the firm.

Ans.

In case of a Private firm, Future cashflows and growth rate can be computed based on past trends, Industry operations but however Required rate of return will vary from buyer to buyer. That is why it might be difficult to use this model here.

B. A biotechnology firm, with no current products or sales, but with several promising product parents in the pipeline.
Ans.

In this case, the firm has no background, no current business it is more of a startup idea, We won’t be able to estimate the future cashflows reasonably. Thus, it may not be appropriate to use DCF method.

C. A cyclical firm, during a recession.

Ans.

In case of cyclical firm, during a recession the estimates based on past trends will not be justifiable. Since the business in the recession stage the economic benefits that will flow will be far less than what had been in the past.
D. A troubled firm, which has made significant losses and is not expected to get out of trouble for a few years.

Ans.

In this case, Future economic benefits that will flow to the organization are negative but however the company owners may still expect some money for the assets that business held. Using DCF in this case will return the negative value for the Firm, which is not correct.

E. A firm, which is in the process of restructuring, where it is selling some of its assets and changing its financial mix.

Ans.

Since the business structure is on the verge of a change, using past trends will not be justifiable while computing the Future cashflows and the growth rate. Thus, DCF should not be used.

F. A firm, which owns a lot of valuable land that is currently unutilized.

Ans.

Business, holds some valuable assets which were not operational in past but yet contributes the significant value in total assets of the firm. Value of assets are not considered in DCF, since it only contains the future economic that is expected to flow from the business. In this case it may not come up with a valuation that justifies the worth of the firm.