Question

you will need to complete a paper of a minimum 500 words that compares and contrasts the Enterprise DCF valuation methodology with the Economic Profit valuation methodology. Explain the differences in the two approaches and the benefits and downsides of each.

Answer 1

a)DCF valuation

Dicounted cash flow valuation method uses future cash flows projections and discount them with a suitable rate in order to calculate the present value of the firm.In other words,as per DCF valaution method,a comapny's value is equal to all the cash flow they have that could make future investment and generate money.However,cash in the future always worth less than cash today due to inflation.As the result,net present value should be multiplied with a discounting factor.

Advantages of DCF valuation method:

Since DCF valuation approach is done based on the asset's fundamentals,it is less exposed to the market moods and perception.If investor buys business rather than stocks,DCF valuation is the suitable tool to choose.It can determine what the company is getting when it buys an assets.DCF valuation forces the company to consider the underlying characteristic of comapny.

Disadvantages of  DCF valuation method

The main limitation of DCF is that it require many assumptions.For one,it require correct estimation of future cash flows.The future cash flows would rely on a variety of factors,such as market demand,the status of company,unforseen obstacles and more.Choosing a discount rate for disscounting is also an assumption and would have to be estimated correctly.

b)Economic Profit valuation Method

This method is also known as Economic value added(EVA) valuation.The basic underlying concept of EVA is that if the company's actual return greater than it is expected,the value has been added.It is based on the company's residual profitability which is computed by net operating profit after taxes subtracts the opportunity cost of invested capital.The opportunity cost of invested capital,which is also known as the capital charged,determined by multiplying WACC and the capital invested.

Advantages of Economic Profit valuation Method:

Like DCF,the result of EVA valuation is also to give an intrinsic value from which company owners can see their own business management performance.This helps managers to make a better invetsment decision in both long term and short term.EVA is considered as one of the most relaible measurement of managerial skills of the company owners as well as good indicator of company's value of growth in the future.

Disadvantages of Economic Profit valuation Method:

Although the priciple of EVA valuations is easy to understand,its application is quite complex which needs accurate estimation of cost of capital after tax,and accurate forecasts of capital spends on assets or acquisitions.Futhermore, EVA valaution does not encourage who invest in a lon period project or start ups companies but rather rewards managers who take on business with quick paybacks since it concern about earning level at the moment