Question

Describe each of the following and identify strengths and weaknesses in each. Why are there so many different valuations?

1. Dividend Based Valuation

2. Free Cash Flow Valuation

3. Residual Income Valuation

4. Residual Income Market-to-Book Valuation

5. Free Cash Flow for All Debt and Equity Valuation

6. Intrinsic Valuation

7. Market Based Valuation

Answer 1

(1): Dividend based model (Dividend discount model): It is the method of predicting the price of company's stock. It calculates sum of all dividend payment after discounted back. Dividend is part of company's profit, this model is based on the fact that the value of company is based on the present value of all the future dividend payment.

Strength- This method takes the present value factor in the consideration that is most important.

Weakness- This model takes only dividend in calculating fair value of stock and it does not take income consideration other market conditions.

(2): Free cash flow method- Free cash flow is the cash that is generated after cash outflow. Free cash flow tells the money left for investors. It also represents the ability of company to pay dividend. It calculates intrinsic value of stock.

Strength- This model takes into account all the cash inflows and outflows.

Weakness- It does not consider non cash expenses (depreciation) that is a big factor.

(3): Residual Income Valuation: On the basis of this method, value of stock can be calculated by taking sum of company's book value and present value of expected future residual income and discounted with the true cost of capital.

Strength- This method takes the cost of capital as discounting factor. This model is not impacted by negative or unpredictable cash flows.

Weakness- This method cannot be used to compare the divisions of different sizes. This model does not take into account dividend and other factors.

(4): Market Based Valuation: It uses price multiples and enterprise multiples. It calculates stock value based on the ratios like price to book, price earning, EV/EBITDA and market data.

Strength- It takes into account the current market elements.

Weakness- It does not take into account the present value factor.