In an equity valuation theory and practice, there are generally two valuation approaches: 澳洲幸运5官方开奖结果体彩网:discounted cash flows (DCF) and 澳洲幸运5官方开奖结果体彩网:comparables.

The DCF Model

The DCF model refers to a group of approaches that are also called “present value models.” These traditionally assume the value of an asset equals the 澳洲幸运5官方开奖结果体彩网:present value of all future monetary ๊benefits. This model is easy to use when the future cash benefits are known or can be at least reasonably forecasted.

Generally, a DCF model requires the following i🐟nput🍸s:

• Future cash flows
• Any growth rate of the cash flows 
• The 澳洲幸运5官方开奖结果体彩网:required rate of return (opportunity cost), which is used as a 澳洲幸运5官方开奖结果体彩网:discount rate

The most common variations of the DCF model are the 澳洲幸运5官方开奖结果体彩网:dividend discount model (DDM) and the 澳洲幸运5官方开奖结果体彩网:free cash flow (FCF) model, which, in turn, has two forms: 澳洲幸运5官方开奖结果体彩网:free cash flow to equity (FCFE) and 澳洲幸运5官方开奖结果体彩网:free cash flow to firm (FCFF) models. In the DDM, future dividends represent cas💮h flows that are discounted with a relevant requi✱red rate of return.

If companies are expected to increase dividend payouts, this must also be modeled. In addition, a constant growth rate or multiple 澳洲幸运5官方开奖结果体彩网:growth rates repr🦹esenting long-term and short-term growth rates are added to the model.

The Comparables Method

The comparables method uses ratios from an industry, 澳洲幸运5官方开奖结果体彩网:peer group or similar companies to estimate a company’s equity value. The following ratios are mostly used: price-to-earning ratio (P/E), price-to-sales ratio (P/S), and enterprise value-to-earnings before interest, tax, 澳洲幸运5官方开奖结果体彩网:depreciation and 澳洲幸运5官方开奖结果体彩网:amortization (EV/EBITDA), which are also called 澳洲幸运5官方开奖结果体彩网:multiples (because of this, the comparables method is also called the “multiples method.”) The prevailing concept behind the comparable method is the 澳洲幸运5官方开奖结果体彩网:law of one price, which states that similar assets should sell at a similar price. We can rephrase this for company earnings or profit: Companies that have similar revenues and earnings drivers should be worth abo🎀ut the same.

For example, imagine that you want to value the equity of a company that operates in office printing devices business and the 澳洲幸运5官方开奖结果体彩网:trailing-12-month (TTM) 澳洲幸运5官方开奖结果体彩网:earnings per share (EPS) is $0.50. If the TTM P/E ratio for this industry is 18.55x, then by multiplying company EPS by this multiple, we obtain $9.275 (0.5*18.55), which can be assumed to be the intrinsic value of the company's 澳洲幸运5官方开奖结果体彩网:common stock.

Which Model to Use

The choice between these 澳洲幸运5官方开奖结果体彩网:two alternative valuation models will depend on specific factors, such as availability and accuracy of the inputs (revenue drivers, 澳洲幸运5官方开奖结果体彩网:business cycles, etc.).

Dividend-Paying, Mature and Stable Companies

The DDM model is best applied for stable and mature 澳洲幸运5官方开奖结果体彩网:public companies that pay dividends. For example, BP plc. (BP), Microsoft Corporation (MSFT) and Wal-Mart Stores, Inc. (WMT) pay regular dividends and can be characterized as stable and mature bu﷽sinesses. Therefore, the DDM can be applied to value these companies.

The FCF model can be used to calculate the valuation of companies that do not pay dividends or pay dividends in an irregular fashion. This model is also applied for those companies with a 澳洲幸运5官方开奖结果体彩网:dividend growth rate that does not pr✨ꦿoperly capture the earnings growth rates.

Companies with Diverse Revenue Drivers

When a company valued has a diversified revenue source, the free cash flow method can be a better approach than the comparable method, simply because finding a true comparison can be problematic. Today there are a number of 澳洲幸运5官方开奖结果体彩网:large-cap companies with diversified revenue drivers. This feature makeꦺs it challenging to find a relevant peer group, company, or even industry multiples.

For example, both Canon Inc. (CAJ) and Hewlett-Packard Company (HPQ) are large manufacturers of printing machines for business and personal use. However, HP’s revenue also is derived from the computer business. HP and Apple are both competitors in the computer business, but Apple derives its revenue mostly from sales of smartphones and its built-in app store.

Apparently, neither Canon and HP, nor HP and Apple, ca🌠n be in a peer group in order to use a peer group multipl🅷e. 

Valuation of Private Companies

There is no straightforward choice of 澳洲幸运5官方开奖结果⛄体彩网:valuation model for private companies. It will depend on the maturation of the private company and the avaꦡilability of model inputs. For a stable and mature company, the comparables method can be the best option.

In general, it is very complicated to get the inputs required for the DCF model from private companies. The beta, which is one of the key inputs for a returns estimation of a private company, is best estimated using comparable firms’ betas. This makes it challenging to apply the ♕DCF model.

Private companies do not distribute regular dividends, and therefore, future dividend distribution is unpredictable. The free ജcash flow model would also be unreliable for valuing relatively new private companies due to the high uncertainty surrounding the business itself. However, in the early stages of a private company with a high growth rate, the FCF model may be a bett🐟er option for common equity valuation. 

Valuation of Cyclical Companies

Cyclical companies are those that experience high volatility of earnings based on business cycles. This can lead to difficulties in 澳洲幸运5官方开奖结果体彩网:forecasting future earnings. Forecasting earnings is a base for the DCF models (be it DDM or FCF model). The relationship between risk and 𓆏return implies that increased risk shall be accounted for in an increased discount rate, making the model even more complicated. As a result, if an investor chooses the DCF model to value a cyclical company, they will most likely get inaccurate results. The comparable method can better solve the cyclicality prꦬoblem.

The Bottom Line

A mix of factors impacts the choice of which equity valuation model to choose. No one model is ideal for a certain type of company. Ideally, both models should yield close results, if not the same. The DCF model requires high accuracy in forecasting future dividends or free cash flows, whereas the comparables method requires the availability of a fair, comparable peer group (or industry), since this model is based on the law of one price, which states that similar goods should sell at similar prices (thus, similar revenues earned from ꦏthe similar sources should be similarly priced).