Question 1 What are the tradeoffs in using Multiples versus DCF analysis?
1. Forecast revenue for each year for from the firm’s financial data. 2. Select appropriate discount rate based on WACC
3. Discount each cashflow back to it present value
4. Obtain the terminal value through an application of terminal value multiple 5. You add these values together
6. Using this method, Martin calculates the price of Cox’s share to be $54.29
1. Identify comparable firms that have growth, cashflow and risks similar to those of target firm whose value is in question. 2. Obtain the individual multiple or ratio of the firm’s price to their financial data, such as EBITDA. 3. Average these multiples to obtain the industry average multiple. 4. Adjust this industry multiple and apply it to the target firm to get that firm’s value. 5. Using a multiple of 20.9, Laura Martin calculates the price of Cox’s share to be $50.00
Advantage of multiple
• With multiple, there’s no need to go through the process of forecasting future revenue with great uncertainty. It simply relies on current financial statement of comparable firms to obtain the industry average multiple. • This process is simple to understand and easy to apply. As a result, the information is also cheap to obtain compared to the high cost of research and calculation required for DCF analysis. • By basing valuation upon data of comparable firms, it reflects the current mood of the market and obtain a relative value. • Good for private firm when datas are not readily available and prevalent measure among particular industries such as cable industry.
Disadvantage of multiple
• According to Martin, Multiple simply doesn’t ask the right questions. • In particular, the EBIDTA figure inflates the earning of the firm, as it ignores “all the bad stuff” in its abbreviation. Furthermore, it is a pro forma figure which is very vulnerable to accounting manipulation. • It goes through a basic arithmetic process of averaging. When this is done in a context with very few comparable firms, the valuation may include substantial errors. Also, comparable firms are often chosen from the same industry, as opposed to choosing firms with the same growth, risk and revenue. As we will see later, this can be quite problematic. • The adjusting process applied to industry average multiple is subjective and non uniform. It differs from analyst to analyst and can be quite arbitrary. • It relies on historical and current data to obtain industry multiple. In that sense, it is backward looking rather than forward looking, and reflects only the relative value as opposed to the fundamental or intrinsic value of a firm.
Advantage of DCF:
• According to Laura, DCF valuation simply asks the right questions. • DCF valuation obtains the closest thing to intrinsic stock value, through fundamental analysis of financial data. In this respect, DCF holds significant advantage over Multiple analysis. • For instance, it factors in the time value of money, which is critical in financial analysis. It is also forward looking as opposed to backward looking. . • Furthermore, compared to multiples. It is not as vulnerable to accounting conventions and manipulation • Finally, it relies on specific data from the firm to obtain specific value for the firm, without relying on arbitrary industry average.
• However, with DCF valuation, the biggest disadvantage is that you have to forecast future revenue, which is often surrounded by great deal of uncertainty. As a result, forecasted cashflow are often inaccurate. • Its difficult to calculate and very difficult to calculate for private firms. • Undervalue asset that produces little or no cashflow.
• WACC is non constant in reality but its assumed to be constant here.
So the trade off is between the simplicity and market oriented nature of multiple analysis against the fundamental and firm specific...
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