In an equity valuation theory and practice, there are generally two valuation approaches: 澳洲幸运5开奖号码历史查询:discounted cash flows (DCF) and 澳洲幸运5开奖号码历史查询: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开奖号码历史查询:present value of all future monetary benefits. This model is easy to us൲e when the future cash benefits are known or can be at least r𒈔easonably forecasted.

Generally, a DCF 𝐆model requires the following inputs:

• Future cash flows
• Any growth rate of the cash flows 
• The 澳洲幸运5开奖号码历史查询:required rate of return (opportunity cost), which is used as a 澳洲幸运5开奖号码历史查询:discount rate

The most common variations of the DCF model are the 澳洲幸运5开奖号码历史查询:dividend discount model (DDM) and the 澳洲幸运5开奖号码历史查询:free cash flow (FCF) model, which, in turn, has two forms: 澳洲幸运5开奖号码历史查询:free cash flow to equity (FCFE) and 澳洲幸运5开奖号码历史查询:free cash flow to firm (FCFF) models. In the DDM, future dividends represent cash flows tha🐬t are discounted with a relevant required rate of returꦡn.

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开奖号码历史查询:growth rates representing long-term♚ and sh🔥ort-term growth rates are added to the model.

The Comparables Method

The comparables method uses ratios from an industry, 澳洲幸运5开奖号码历史查询: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开奖号码历史查询:depreciation and 澳洲幸运5开奖号码历史查询:amortization (EV/EBITDA), which are also called 澳洲幸运5开奖号码历史查询: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开奖号码历史查询:law of one price, which꧒ 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 about 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开奖号码历史查询:trailing-12-month (TTM) 澳洲幸运5开奖号码历史查询: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开奖号码历史查询:common stock.

Which Model to Use

The choice between these 澳洲幸运5开奖号码历史查询:two alternative valuation models will depend on specific factors, such as availability and accuracy of the inputs (revenue drivers, 澳洲幸运5开奖号码历史查询:business cycles, etc.).

Dividend-Paying, Mature and Stable Companies

The DDM model is best applied for stable and mature 澳洲幸运5开奖号码历史查询:public companies that pay dividends. For example, BP plc. (BP), Microsoft Corporation (MSFT) and Wal-Mart Stores, Inc. (WMT) pay regular divꦦidends and can be characterized as stable and mature businesses. Therefore, the DDM can be applied to valueꦯ 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开奖号码历史查询:dividend growth rate that does not properly capture the earnings gro༒wth 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开奖号码历史查询:large-cap companie𓃲s with diversified 𓆉revenue drivers. This feature makes 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 andಌ HP, no🍌r HP and Apple, can be in a peer group in order to use a peer group multiple. 

Valuation of Private Companies

There is no straightforward choice of 澳洲幸运5开奖号码历史查询:valuation model for privat༺e comꩲpanies. It will depend on the maturation of the private company and the availability 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 company𝐆, is best estimated using comparable firms’ betas. This makes it challen🐈ging to apply the DCF model.

Private companies do not distribute regular dividends, and therefore, future dividend distribution is unpredictable. The free cash 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 privat꧟e company withꦚ a high growth rate, the FCF model may be a better 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开奖号码历史查询:forecasting future earnings. Forecasting earnings is a base for the DCF models (be it DDM or FCF model). The relationship between risk and return implies that increased risk shall be accounted for in an increased discount rate, making the mode🔯l 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 cyclicali꧋ty problem.

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 simila🎶r prices (thus, similar revenues earned from the similar sources should be similarly priced).