Choosing the Right Valuation Model

All discounted cash flow models ultimately boil down to estimating four inputs -current cashflows, an expected growth rate in these cashflows, a point in time when the firm will be growing a rate it can sustain forever and a discount rate to use in discounting these cashflows. In this section, we will examine the choices available in terms of each of these inputs.

In terms of cashflows, there are three choices - dividends or free cashflows to equity for equity valuation models, and free cashflows to the firm for firm valuation models. Discounting dividends usually provides the most conservative estimate of value for the equity in any firm, since most firms pay less in dividends than they can afford to. In the dividend policy section, we noted that the free cash flow to equity, i.e., the cash flow left over after meeting all investment needs and making debt payments, is the amount that a firm can pay in dividends. The value of equity, based upon the free cash flow to equity, will therefore yield a more realistic estimate of value for equity, especially in the context of a takeover. Even if a firm is not the target of a takeover, it can be argued that the value of equity has to reflect the possibility of a takeover, and hence the expected free cash flows to equity. The choice between free cash flows to equity and free cash flows to the firm is really a choice between equity and firm valuation. Done consistently, both approaches should yield the same values for the equity in a business. As a practical concern, however, cash flows to equity are after net debt issues or payments and become much more difficult to estimate when financial leverage is changing over time, whereas cashflows to the firm are pre-debt cash flows and are unaffected by changes in the leverage. Ease of use dictates that firm valuation will be more straightforward under this scenario.

While we can estimate any of these cashflows from the most recent financial statements, the challenge in valuation is in estimating these cashflows in future years. In most valuations, this takes the form of an expected growth rate in earnings that is then used to forecast earnings and cash flows in future periods. The growth rates estimated should be consistent with our definition of cashflows. When forecasting cashflows to equity, we will generally forecast growth in net income or earnings per share that are measures of equity earnings. When forecasting cashflows to the firm, the growth rate that matters is the growth rate in operating earnings. 1

The choice of discount rates will be dictated by the choice in cash flows. If the cash flow that is being discounted is dividends or free cash flows to equity, the appropriate discount rate is the cost of equity. If the cash flow being discounted is the cash flow to the firm, the discount rate has to be the cost of capital.

The final choice that all discounted cash flow models have to make relates to expected growth patterns. Since firms have infinite lives, the way in which we apply closure is to estimate a terminal value at a point in time and dispense with estimating cash flows beyond that point. To do this in the context of discounted cash flow valuation, we have to assume that the growth rate in cash flows beyond this point in time are constant forever, an assumption that we refer to as "stable" growth. If we do this, the present value of these cash flows can be estimated as the present value of a growing perpetuity. There are three questions that every valuation then has to answer:

1. How long in the future will a company be able to grow at a rate higher than the stable growth rate?

2. How high will the growth rate be during the high growth period and what pattern will it follow?

3. What will happen to the firm's fundamentals (risk, cash flow patterns etc.) as the expected growth rate changes?

At the risk of being simplistic, we can broadly classify growth patterns into three categories - firms which are in stable growth already, firms which expect to maintain a 'constant" high growth rate for a period and then drop abruptly to stable growth and firms which will have high growth for a specified period and then grow through a transition phase to reach stable growth at a point in time in the future. As a practical point, it is important that as the growth rate changes, the firm's risk and cash flow characteristics change as well. In general, as expected growth declines towards stable growth, firms should see their risk approach the "average" and reinvestment needs decline. These

1 We should generally become much more conservative in our growth estimates as we move up the income statements. Generally, growth in earnings per share will be lower than the growth in net income, and growth in net income will be lower than the growth in operating income.

choices are summarized in Figure 12.1. We will now examine each of these valuation models in more detail in the next section.

Figure 12.1: The Ingredients in a Valuation

Figure 12.1: The Ingredients in a Valuation

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