Question

a) Set out and explain three cash flow based valuation techniques for determining the intrinsic value of a company’s equity.

b) Set out and explain two abnormal income based valuation techniques for determining the intrinsic value of a company’s equity.

c) Provide a balanced discussion of the theoretical merits and weaknesses of each of the two types of model described in parts (a) and (b).

d) Provide a summary of the empirical evidence relating to the performance of each type of model.

Answer 1

a) Set out and explain three cash flow based valuation techniques for determining the intrinsic value of a company’s equity.

Valuation based on what the company can generate in the future is the most common method of valuation. As in the analysis of investment/financing projects, these methodologies analyze the financial flows that the company can generate in the future and which can be made available to the holders of the capital of the company (equity and debt). There are quite large array of methodologies within cash-flow base methods; some of the most widespread are:

1. Dividend Discounted Model – DDM.
2. Discounted Cash Flow – DCF:
   1. Free Cash Flow to the Firm – FCFF.
   2. Free Cash Flow to Equity – FCFE.
3. Enterprise Value Added – EVA.
4. Adjusted Present Value – APV.

Dividend Discounted Model – DDM.

The dividend discount model (DDM) is a quantitative method used for predicting the price of a company's stock based on the theory that its present-day price is worth the sum of all of its future dividend payments when discounted back to their present value. It attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and takes into consideration the dividend payout factors and the market expected returns. If the value obtained from the DDM is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy, and vice versa.

Discounted Cash Flow – DCF:

Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. This applies to both financial investments for investors and for business owners looking to make changes to their businesses, such as purchasing new equipment.

Enterprise Value Added – EVA.

Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the true economic profit of a company. This measure was devised by management consulting firm Stern Value Management, originally incorporated as Stern Stewart & Co.

b) Set out and explain two abnormal income based valuation techniques for determining the intrinsic value of a company’s equity

The abnormal earnings valuation model is a method for determining a company's equity value based on both its book value and its earnings. Also known as the residual income model, it looks at whether management's decisions will cause a company to perform better or worse than anticipated.

The model is used to forecast future stock prices and concludes that investors should pay more than book value for a stock if earnings are higher than expected and less than book value if earnings are lower than expected.

How to Calculate an Abnormal Earnings Valuation

The abnormal earnings valuation model is one of several methods to estimate the value of stock or equity. There are two components to equity value in the model: A company's book value and the present value of future expected residual incomes.

The formula for the latter part is similar to a discounted cash flow (DCF) approach, but instead of using a weighted average cost of capital (WACC) to calculate the DCF model's discount rate, the stream of residual incomes are discounted at the firm's cost of equity.

What Does the Abnormal Earnings Valuation Model Tell You?

Investors expect stocks to have a "normal" rate of return in the future, which approximates to its book value per share. "Abnormal" is not always a negative connotation, and if the present value of future residual incomes is positive, then company management is assumed to be creating value above and beyond the stock's book value.

However, if the company reports earnings per share that comes in below expectations, then management will take the blame. The model is related to the economic value added (EVA) model in this sense, but the two models are developed with variations.

Example of Using the Abnormal Earnings Valuation Model

The model may be more accurate for situations where a firm does not pay dividends, or it pays predictable dividends (in which case a dividend discount model would be suitable), or if future residual incomes are difficult to forecast. The starting point will be book value; the range of total equity value after adding the present value of future residual incomes would thus be narrower than, say, a range derived by a DCF model.

However, like the DCF model, the abnormal earnings valuation method still depends heavily on the forecasting ability of the analyst putting the model together. Erroneous assumptions for the model can render it largely useless as a way to estimate the equity value of a firm.

c) Provide a balanced discussion of the theoretical merits and weaknesses of each of the two types of model described in parts (a) and (b).

Advantages

DCF Valuation truly captures the underlying fundamental drivers of a business (cost of equity, weighted average cost of capital, growth rate, re-investment rate, etc.). Consequently, this comes closest to estimating intrinsic value of the asset/business.

Unlike other valuations, DCF relies on Free Cash Flows. To a larger extent, Free Cash Flows (FCF) are a reliable measure that eliminate the subjective accounting policies and window dressing involved in reported earnings. Irrespective of whether a cash outlay is categorized as an operating expense in P&L, or capitalized into an asset on balance sheet, FCF is a true measure of the money left over for investors.

Besides explicitly considering the business drivers involved, DCF allows investors to incorporate key changes in the business strategy in the valuation model, which otherwise will go unreflected in other valuation models (like relative, APV, etc.)

While other methods like relative valuation are fairly easier to calculate, their reliability becomes questionable when the entire sector or market is over-valued or under-valued. DCF cuts across through this quandary and predicts the best possible instrinsic value.

Most importantly, DCF model can be used as a sanity check. Instead of estimating the fair intrinsic value, the current share price of the company can be plugged into the model, and working backwards, DCF model will tell how much the company’s stock is over-valued or under-valued, and also whether the current stock price is justified or not.

Disadvantages

DCF Valuation is extremely sensitive to assumptions related to perpetual growth rate and discount rate. Any minor tweaking here and there, and the DCF Valuation will fluctuate wildly and the fair value so generated won’t be accurate.

It works best only when there is a high degree of confidence about future cash flows. But if the company’s operations lack visibility, it becomes difficult to predict sales, operating expenses and capital investment with certainty. While forecasting cash flows for the next few years is difficult, pushing them out perpetually (mandatory for DCF Valuation) becomes almost impossible. As such, DCF method is susceptible to error if not properly accounted for these inputs.

One major criticism of DCF is that the terminal value comprises far too much of the total value (65-75%). Even a minor variation in the assumptions on terminal year can have a significant impact on the final valuation.

Limitations of the Abnormal Earnings Valuation Model

Any valuation model is only as good as the quality of the assumptions put into the model. In the case of the book value per share used in the abnormal earnings valuation, a company's book value can be affected by events such as a share buyback and this must be factored into the model. Additionally, any other events that affect the firm's book value must be factored in to make sure the results of the model are not distorted.