Managerial Finance: An Overview of Valuation Models
Finance professionals use managerial finance to evaluate the impact of various finance techniques on the organization, as well as to identify areas of improvement in financial practices in an effort to prevent the loss of revenue. To ensure the validity of their calculations, finance experts have developed a range of valuation models that streamline the process of evaluating the worth of both tangible and non-tangible assets. While there is no valuation model that has proven effective in every situation, it is important that finance professionals sharpen their understanding of managerial finance so they can select the most appropriate valuation models for their business to use when preparing for significant financial events, like large purchases or the sale of business assets.
Business valuation models are generally categorized into two groups: absolute valuation models and relative valuation models. Both groups of techniques are designed to determine the value of a business or stock, but they accomplish this in two distinctly different ways.
- Absolute valuation models are focused entirely on the characteristics of the business or asset being valued and do not incorporate the impact that other companies within the industry may have on a company’s financial trajectory. These valuation models are commonly used to gather baseline information about an equity stock’s value.
- Relative valuation models are designed to take a firm’s relationship with other companies in the same industry into account during the valuation process. Therefore, these valuation models account for extrinsic market factors that absolute valuation models do not. The data observed in relative valuation models should be used in conjunction with absolute valuation data to develop a well-rounded representation of the company’s true value.
Given that each valuation model is formulated to achieve a specific perspective on a business’s value, using a strategic mix of the following absolute and relative valuation models is the best way for a finance professional to ensure that the value of their organization or other asset is properly calculated and provides the most accurate and appealing data for prospective buyers or stockholders.
Discounted Cash Flow Model
Absolute valuation models often incorporate a discounted cash flow element–a model that relies on the firm’s discounted future cash flows to determine the current equity of the business. Discounted cash flow models are adjusted to account for the time value of money, which hinges on the idea that money earned in the future is less valuable than money earned today. This means that any supposed potential future cash flows are estimated and discounted to decide their present value to the investor. In the first step of this calculation, the future cash flows are estimated by comparing current cash flows with historical ones to estimate the rate of growth for specific cash flows. This information is then used to estimate what trends each cash flow will take in the future based on the firm’s current position in the market. The estimated cash flows for the following years are then combined and any debts that may exist are subtracted to calculate a fair enterprise value for the firm.
Discounted cash flow models are frequently used to analyze the risks associated with the development of real estate, corporate management of financial assets and equity investments. Finance professionals who are responsible for modeling the discounted cash flow should understand that the usability of a discounted cash flow model is only as good as the data inputted to produce it.
Dividend Discount Model
The dividend discount model is an absolute valuation model that can be used to value a firm based on the estimated value of all future dividends, while also accounting for the time value of money. This method, like the discounted cash flow model, calculates the present value of future assets; however, the subject is future dividends earned per share rather than future cash flow, allowing a firm to verify whether its stock is currently being traded at a rate that reflects its actual worth. Having insight into the actual value of its stock allows organizations to accurately calculate their share prices with minimal complexity.
One caveat to using the dividend discount model is that the business being valued must regularly pay out dividends that can be used in the calculations. Furthermore, the companies that do offer dividends must maintain an almost constant growth rate to obtain the highest level of accuracy in the valuation. Most businesses that are new to the trade market will not be able to maintain thorough consistency with their dividends in the beginning, and therefore, the dividend discount model is mostly utilized by finance professionals who perform equity valuation procedures for larger, mature companies.
Comparable Company Analysis Model
The comparable company analysis model is a relative valuation model that involves compiling statistics taken from the metrics of publicly traded firms that operate within the same industry and comparing them to the statistics of the organization(s) being valued. The comparable operational metrics of publicly traded organizations generally include publicly available information such as earnings releases, financial projections, analyst research reports and relevant material events that may have impacted the performance of a firm since its most recent reporting date. Material events that should be considered are acquisitions, disposals, stock repurchases, debt financing and any large legal settlements. When this information is analyzed using the comparable company analysis model, it helps determine the high, low, mean and median statistics for each factor being measured for every company within the group, while also helping finance professionals accurately define their company’s true value. The data found in this list can be used in conjunction with the intrinsic valuation data gained from absolute valuation models to determine whether a financial asset is currently overvalued or undervalued in the marketplace.
Net Asset Value Model
Understanding the market value of each share in a company, mutual fund or exchange-traded fund often includes calculating the net asset value of the asset in question. The net asset value, like a company’s stock price, is a representation of how much a single share in a particular fund is worth. Therefore, regardless of the fund being evaluated, investors and finance professionals should always consider whether the net asset value is the best way to determine the overall potential of an investment, as some assets may be valued more accurately than others when using this model. Applying this valuation model means subtracting the fund’s debts and liabilities from the total value of its assets, then dividing the answer by the number of outstanding shares. In this calculation, liabilities include all major expenses, such as staffing costs, utilities and other short- or long-term operational expenses.
Exchange-traded funds have their net asset values calculated several times per minute during the day, ensuring that investors and other finance professionals have the most accurate representation of a fund at any given time. The net asset value model is also a powerful tool for finance professionals who need to value an oil, gas or energy company’s stock, as it can simulate a production decline rate for the companies within an industry and estimate a company’s cash flow until reserves are depleted.
Investment banking and corporate finance recruiters are constantly on the lookout for new financing opportunities, giving skilled finance professionals who have an in-depth understanding of calculating the true enterprise value of a company and the market value of individual shares of stocks the chance to effectively take advantage of such opportunities for their organizations. One means for helping to provide increased value to their organization is for individuals in the field to enhance their knowledge and skills by attaining a Master of Business Administration with a concentration in finance, furthering their potential to efficiently advance their employer’s financial objectives.
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Business Valuations, Larry J. Kasper
How does the Dividend Discount Model value stocks?, Business Insider