Fundamental Determinants of Residual Income
The fundamental drivers of residual income can be recognized by assuming a constant growth in dividends and earnings. Assuming constant growth, a stock’s intrinsic value under the residual income model, can be expressed as: $$\text{V}_{0}=\text{B}_{0}+\frac{\text{ROE}-\text{r}}{\text{r}-\text{g}}\text{B}_{0}$$ If the return on…
Valuation with Comparables
Valuation based on Comparables The P/E valuation method is used to estimate a company’s stock value by applying a benchmark multiple to the company’s actual or forecasted earnings. An equivalent approach is to compare a stock’s actual price multiple…
Single-Stage Residual Income Valuation
Single-Stage Residual Income Valuation The single-stage residual income (constant-growth) model assumes that a firm has a constant return on equity and constant earnings growth rate through time. $$\text{V}_{0}=\text{B}_{0}+\frac{\text{ROE}-\text{r}}{\text{r}-\text{g}}\text{B}_{0}$$ Example: Using a Single-stage Residual Income Model A company’s current book…
Valuation Discounts and Premiums
Control and/or marketability adjustments are often included in valuations of interests in private companies. Discount For Lack of Control (DLOC) The discount for lack of control is a reduction in a company’s share value as a result of a…
Asset-Based Approach (Cost Approach)
The principle underlying the asset-based approach is that the value of ownership of an enterprise is equivalent to the fair value of its assets less the fair value of its liabilities. The asset-based approach, also known as the cost…
Market-Based Valuation
The market approach uses direct comparisons to public companies to estimate the fair value of an equity interest in a private company. The three major variations of this are: The guideline public company method (GPMC). The guideline transactions method…
Required Rate of Return Models
The CAPM $$\begin{align*}\text{Required return on equity}&= \text{Risk-free rate} \\&+ (\text{Beta} \times \text{Market risk premium})\end{align*}$$ The CAPM is generally inappropriate for private entities. Expanded CAPM $$\begin{align*}\text{Required return on equity} &= \text{Risk-free rate} + (\text{Beta} \times \text{Market risk premium}) \\&+ \text{Small…
Discount Rate Estimation Elements
Challenges in estimating a required rate of return: Size premium When valuing private companies, size premiums are used in developing equity return requirements. Estimating a premium using small public firms may have an upward bias since many of them…
Income Approach Methods of Private Company Valuation
There are three forms of income approach: Free Cash Flow Method (Discounted Cash Flow Method) This method values an asset based on estimates of future cash flows for several years until cash flows are expected to stabilize. Then, a…
Earnings Normalization and Cash Flow Estimation Issues
Private company valuations may require adjustments to estimate the company’s normalized earnings as their reported earnings reflect discretionary expenses. This results in differences between reported earnings and normalized earnings. Normalized earnings are economic benefits adjusted for nonrecurring, non-economic, or…
