Question

There are two major approaches to corporate valuation: a) using comparable firms (via multiples, i.e. ratios) and b) discounted cash flows based methods (FCF models, capital budgeting metrics all fall into this category). Based on the case, which method (A or B above) do you find more useful? Briefly discuss relative strengths and weaknesses you can think of for both methods. Answer detailed.

Answer 1

Valuation using comparable firm method is suitable for listed companies but for non listed companies this is not a good approach. Whereas, FCF models applies to both listed and non listed companies.

The discount rate used in the FCF model can have error in real world scenario as the discounting interest rate can be changed in future due to change in economic scenario, ratings etc. However, the comparable firm method does not have that weakness.

The comparable firm method is more accurate where governance and audit is more transparent. So, in a market where comparable firms financial statements and stock price is inflated than original, it will not the correct valuation. Whereas FCF model will not have such weakness.

An analyst need to be very accurate when calculating the Free Cash Flow of a firm and the probable future cash flow form it's future projects and this may lead to error which in turn may give incorrect valuation of a firm. Whereas, comparable firm method doesn't have that weakness.

In summary, where market is transparent and regulatory authority is strict enough to publish true picture of financial statement or condition comparable firm method is better and vice versa.