Question

Part A

1 a) List and explain three different major characteristics of companies for which it is not appropriate to use the Discounted Free Cash Flows methods of Stock Valuation.

b) List and explain three different major strengths of the Discounted Free Cash Flows methods of Stock Valuation compared to the Comparables methods of stock Valuation.

c) List and explain three different major strengths of the Comparables methods of Stock Valuation compared to the Discounted Free Cash Flows methods of Stock Valuation.

Answer 1

1)a) Three Different Major Characteristics where Discounted Free cash Flow model cannot be used

i) Long Term Growth

One of the foremost assumptions in Discounted Free cash Flow model concept is Long term growth rate in projected cash flows. If Company is incorporated with particular object (say Joint venture companies incorporated to built an unit or to collect from debtors) and it will be shut down once object is achieved, then it is inappropriate to apply Discounted Free cash Flow model. Since there is neither growth rate nor cash flows, it cannot be applied in these companies.

ii) Uncertain cash flows

When it is very difficult to project cash inflows or outflows of the company such defense , aerospace, then it is inappropriate to use Discounted Free cash Flow model.

iii) Very high Volatility

Discounted Free cash Flow model will be calculated based on many assumptions. Since it is very sensitive, even a single assumption changes then whole model needs to be recalculated. The company, which are high volatile in nature such as Energy, Healthcare where market keep changing every now & then, cannot use Discounted Free cash Flow model.

b) Three Major strengths of Discounted Free cash Flow model

i) Own Assumptions can be made

The company can make its own assumptions based on its track record and projections. It does not have to rely on figures of its peers.

ii) Analyse Opportunities & threats

As the company making assumptions on its own track record, it can analyse more accurately its opportunities & threats prevailing in the market. It can work on its strengths & weaknesses based on accurate analysis.

iii) Decide Discount factor

Based on its own assumptions and analysis, it can decide what is alternative expected rate of return in investment. It does not have to use rely on same discount factor as its peers

c) Three Major strengths of Comparable methods

i) Easy to gather financial information

Once the right comparable companies are selected, it is easy find bench marked parameters can be set.

ii) Involves less time to calculate

As the data are readily available, it does not take much time to valuate the shares.

iii) Easy access to market assumptions

Since peers data is being used in valuation, industries' volatility & assumptions are automatically captured in valuation