Question

1. Compare and contrast valuation models based on discounted cash flows and valuation approaches based on the relevant multiples of comparable investments.

Answer 1

Discounted Cash Flow Valuation:

This approach assumes that the intrinsic value of a firm will be computed based on the future cash flows earned by the Firm discounted at the minimum required rate of return expected by investors and after deducting the amounts owed to outside entities like bondholders, Government etc. The value of a firm is basically based on its Intrinsic value which further depends on the future cash flows that the Firm can generate.

Relative Valuation Method:

This method doesn't value a firm based on its intrinsic value, instead it uses a benchmark valuation, i.e, based on price multiples prevailing in the particular industry (considering the multiples of comparable companies). Such multiples can be Price to earnings ratio, Price to Book value ratio etc. For example,  when we make an index of all the stocks in the technical industry, we get a P/E ratio of 25. This means that the market believes that each stock is worth approximately 25 times what its current earnings are. Now, if we see that Yahoo is valued only at 17 times its earnings even though the market is valued at 25 times its earnings. We then study the details of Yahoo’s business to find legitimate reasons as to why it should be so undervalued. If the reasons are found, then the stock is trading at fair value.

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