Free Cash Flow to Equity (FCFE) Model
- Advantages: aims to calculate a company’s capacity to pay future dividends, going beyond simply discounting expected dividends. This approach may provide a more useful valuation, especially when the company does not pay a dividend or dividends are sporadic.
- Disadvantages: calculation is more complicated than a standard dividend discount model, and more assumptions must be made.
Gordon (Constant) Growth Dividend Discount Model
- Advantages: useful in valuing defensive companies at a mature life-cycle stage. Calculation is intuitive and simple.
- Disadvantages: while a single growth rate makes the calculation easy, it isn’t always very practical for valuing complex companies in uncertain economic environments.
Multistage Dividend Discount Model
- Advantages: allows for more flexibility than the constant growth model as an analyst can include however many growth rates may be appropriate for a given company’s valuation. This is particularly useful in the valuation of companies at an early stage in their life-cycle.
- Disadvantages: calculation isn’t as clean and simple as the constant growth model. While the model allows for flexibility, it is oftentimes difficult to project multiple separate growth rates in a company’s future.
- Advantages: can take comparable companies into account and may prove particularly useful in valuing companies with negative earnings. Limits the amount of projection necessary and ties the valuation into historical data. Price multiples have shown to be fairly good predictors of future performance.
- Disadvantages: a comparable company analysis may be skewed by mispricing across the given industry or peer group.
Asset-Based Valuation Models
- Advantages: simple calculation and no projections necessary, particularly useful in valuing firms that are heavy in current assets and light in intangibles. Also useful in supplementing other valuation methods.
- Disadvantages: not usually the best stand-alone option for valuing firms as going concerns. The model doesn’t take into account current or expected cash flows, earnings, or growth rates.
Which of the following models would be the most helpful in valuing a Sillicon Valley startup firm?
A. Multistage dividend discount model
B. Multiplier model
C. Asset-based model
The correct answer is B.
Multiplier models are particularly useful in valuing companies with negative earnings, which is often the case for startup companies. Also, there should be many comparable startups in the same geographical location raising capital, which makes the valuation easier.
Option A is incorrect. While the multistage dividend discount model can include different growth rates, a startup company is rarely paying dividends. Therefore, this model would not be of any help.
Option C is incorrect. A startup firm usually does not have many tangible assets.
Reading 41 LOS 41m:
Explain advantages and disadvantages of each category of valuation model