Issues in Model Selection and Interpretation

For a valuation model to be appropriate, it should have the following three characteristics.

1. Consistent with the Company’s Characteristics

The selection of a good valuation model requires a good understanding of the business. This includes its assets and how it creates value, for example, using an asset-based valuation approach on a natural resource company. 

2. Appropriate given the Availability and Quality of Data

It would not be possible to use a dividend discount model on a company that has never paid dividends and is not expected to pay dividends in the foreseeable future. Similarly, relative valuation models would not be possible for companies that have negative earnings.

3. Consistent with the Purpose of the Valuation

An investor seeking to acquire a controlling equity position in a company would more likely use a free cash flow valuation model to value a company because they would be able to control the dividend policy of a company from such an acquisition.

Analysts frequently use multiple valuation models to estimate the value of an asset. This can be done by giving the valuation models different weights according to their appropriateness.

Question

Which of the following is the least likely criteria used for choosing a valuation approach?

1. Consistent with the company’s characteristics.
2. Appropriateness given the availability and quality of data.
3. Relative valuation model.

Solution

The correct answer is C.

The relative valuation model is a valuation approach that estimates the value of an asset relative to the value of another asset. It is therefore not a criterion used for choosing a valuation approach but a valuation approach in itself.

B is incorrect. Appropriateness of the approach given the availability and quality of data is one of the criteria used to choose a valuation approach. Some valuation approaches would not be possible with certain data, e.g., relative valuation models would not be possible for companies that have negative earnings.

A is incorrect. Consistency with the company’s characteristics is another criterion used for picking a valuation approach. This requires a good understanding of the company and how it creates value.

Reading 20: Equity Valuation: Applications and Processes

LOS 20 (h) Explain broad criteria for choosing an appropriate approach for valuing a given company.