Question

Compare and contrast the valuation of a business using discounted cash flow (DCF) and relative valuation (multiples). What elements do you need to know in order to proceed with each methodology? In what cases would you advise against using DCF? Relative valuation? How would a Federal Reserve interest rate increase affect your valuation? Suppose you decided to use DCB. Discuss how you would estimate the risk premium for the company.

Answer 1

1)

A) Discounted cash flow methods uses an approach where it estimates the series of cash flow occuring at different point of time in future and brings them at their present value today by discounting them at the appropriate rate of Interest .The discounting cash flow method uses different assumptions like revenue growth rate, terminal value, cost of capital. Relative valuation also known as the comparable method, calculates the price of an asset to the market value of similar asset. In relative valuation model, we compare the company values to that of it's competitor or Industry average to get the financial worth of the company.

B) To use the discounted cash flow method, we need to estimate the future cash flow at different points of time, the growth rate in cash flows, the terminal value and the required rate of return to discount the cash flow value. In relative valuation model, we have to select a benchmark with which the asset value can be compared. The benchmark is normally taken to be Industry wide average.

C) DCF model should not be used in cases where the cash flow projection cannot be relied upon, the capital expenditure is not predictable and where the discount rate is less than the growth rate. Relative valuation should not be used in situations where a comparable asset and its market price could not be found and be relied upon as its true value.

D) If the federal reserve is Increasing the Interest rate, the cost of borrowing will Increase, if the cost of borrowing goes up then eventually the weighted average cost of capital will go up. The value of the firm will fall, since we are discounting the cash flow at higher Interest rate the present value would be less.