Equity Valuation: Discounted Cash Flow and Residual Income Models
Valuation plays a very important role when companies are trying to increase their value, raise money, acquire another firm or sell a subsidiary, also when a company decides to go public. Managers, investors and shareholders need to have the most accurate and reliable information in order to make decisions, that is why valuation is a fundamental exercise in corporate finance.
It is pretty evident that whatever the reason, sooner or later there will be a question of how much a firm is worth and very often the answer will not be easy. Hamadi and Hamadeh (2012, p.104) claim that “determining firm’s value has recently become more problematic”.
Valuation is, indeed, a complicated task. It requires taking in consideration a variety of factors, making a number of assumptions and calculations and of course selecting the most appropriate valuation approach. Equity Valuation is the process of estimating the value held by a firm’s equity holders; it should not be confused with Enterprise Valuation, which is the total value of a firm. They are two different values from two different concepts. By having a clear understanding of it, we will be able to incorporate the appropriate cash flows and discount rates to our valuation analysis.
Discounted Cash Flow Models
This models measure the value of equity by discounting the cash flows a firm generates for its equity holders, dividends or equity free cash flow (equity FCF), at their required rate of return. Now, the question would be: which cash flow should we discount? Damodaran (Damodaran Online, 2002) provides a straightforward answer. We should discount dividends for firms which pay dividends that are close to the equity FCF over a long period and for those companies where equity FCF is difficult to determine. On the other hand, we should discount equity FCF for firms that pay dividends which are considerably higher...
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