Valuation Models

The two major valuation models that are based on the going concern assumption are:

1. Absolute valuation models.
2. Relative valuation models.

1. Absolution Valuation Models

These models estimate an asset’s intrinsic value which can be compared to its market price. Absolute value models include present value models and asset-based valuation models.

Present value models, also referred to as discounted cash flow models, rely on the assumption that the value of an asset must be related to the cash flows an investor expects to receive from acquiring the asset. Examples of cash flows include dividends, free cash flow, and residual income. We will all see these models in detail in later readings, but for now:

• Dividends are cash flows at the shareholder level that are paid to shareholders.
• Free cash flows are cash flows from operations after capital expenditures and working capital expenses. There are two types of free cash flows:
  1. Free cash flow to equity (FCFE): These are free cash flow after deducting payments to debt providers.
  2. Free cash flow to the firm (FCFF): These are free cash flows before making payments to the firm’s debt providers.
• Residual income is the excess of accounting earnings over the dollar cost of capital.

Asset-based valuation models use a sum of the market values of a company’s assets. This is often applied to natural resource companies. 

2. Relative Valuation Models

Under relative valuation models, the value of an asset is estimated relative to that of another comparable asset using price multiples and enterprise multiples. The assumption behind this is that similar assets should have similar values.

Price multiples are ratios of stock price to a company’s fundamentals such as price-to-earnings ratio, price-to-book value ratio, and price-to-cash flow ratio.

Enterprise multiples are ratios of enterprise value (total value of common stock and debt net cash and short-term investments) to a valuation fundamental like operating earnings. 

The most commonly used price multiple is the price-to-earnings (P/E) multiple. A stock selling at a lower P/E relative to its comparable is considered relatively undervalued. A common problem with this model is that the comparable stock price might be absolutely overvalued or undervalued. Using the relative valuation approach, the analyst assumes that the comparable asset is fairly priced.

The relative valuation model is also referred to as the method of comparable.

Question

Which of the following is an example of a cash flow used in present value models?

1. Residual income.
2. Price multiple.
3. Enterprise multiple.

Solution

The correct answer is A.

Residual income is one of the cash flows used in the present value models. The other is dividends and free cash flow.

B is incorrect. Price multiples are ratios of stock price to a company’s fundamental to estimate value. They fall under the relative valuation models.

C is incorrect. Enterprise multiples are ratios of enterprise value to a valuation fundamental. They fall under relative valuation models.

Reading 22: Equity Valuation: Applications and Processes

LOS 22 (f) Contrast absolute and relative valuation models and describe examples of each type of model.