Question

We have examined several methods to value a firm including DCF, residual income, price to book as a proxy for firm value, and price to earnings as a proxy for firm value. Please explain the key components of these four methods and any critical underlying assumptions that we discussed in class or that have been brought to your attention as you completed your annual report project.

Answer 1

Answer

Several methods of valuation of firm are as follows:

1

Discounted Cash Flow Method:It is the most widely accepted method of calculating intrinsic value

It tried to value an asset today absed on all future cash projections that an asset can make available to investors in future.

Key Components of Discounted Cash Flows are:

1

Free Cash Flows- Cash available with investors after all expenses,taxes and interest incurred that can be used to enhance the wealth of shareholders.

2

Terminal Value-Value of the asset beyond a forecast period.

3

Discount Rate-The expected rate of return which is used to discount the free cash flows.

Assumptions:

1

All cash flows occur at the end of year.

2

A perfect capital market

3

Cash flows are known with certaninty with no risks involved

2

The residual income approach is the measurement of the net income that an investment earns calculated by the minimum rate of return.

Based on measurement the business option is valued ,accepted or rejected.

The residual income model attempts to adjust a firm's future earnings estimates, to compensate for the equity cost and place a more accurate value to a firm. Although the return to equity holders is

Key Components

1

Residual Income-

Any profit ecxeeding minimum rate of return of the company.

2

Return on investment- a rate calculated on investment.

Assumptions-

1

Excessive or surplus cash balance is always available beyond the rate of return

2

Future cash estimates can be calculated with full certainity.

3

No terminal values

4

No set dividend patterns

3

Price to book value as a proxy of firm value

Price to book value ratio is one of the relative valuation tools used to measure stock valuation.

PB Ratio=Market price per share/book value per share

Lower is the PB Ratio,stock is undervalued.

a P/B ratio above 1 indicates that the investors are willing to pay more for the company than its net assets are worth.

Key Components:

1

Stock price/market price per share

2

Book value or shareholders equity value per share as reflected on the balance sheet of the company.

Assumptions:

1

It takes book value of assets where intangible assets are totally ignored.Only tangible asseta are accounted for

2

Tangible assets are valued at a fair price.

4

Price to Earning method

The amount of dollars which an investor expect to invest in the company in order to earn one dollar earning

The price-to-earnings ratio (P/E) is a valuation method used to compare a company’s current share price to its per-share earnings.

Price to Earning Ratio-Market value per share/earning per share

How much investor is willing to pay in the company per dollar of his earnings.

High PE ratio means investor is expecting higher return from the company.

Key Components of Price to earning ratio

1

Price of the stock

2

Earning per share

Assumptions

1

Investor assumes that company's growth rate will continue to increase

2

Ignores the risk and uncertainities in future .

3

Dividend growth also will always increase

4

Stocks are fairly priced.