Conclusion

There are two basic approaches to valuation. The first is discounted cash flow valuation, where the value of any asset is estimated by computing the present value of the expected cash flows on it. The actual process of estimation, in either case, generally requires four inputs -

• the length of the period for which a firm or asset can be expected to generate growth greater than the stable growth rate (which is constrained to be close to the growth rate of the economy in which the firm operates),

• the cash flows during the high growth period,

• the terminal value at the end of the high growth period and

The expected growth potential will vary across firms, with some firms already growing at a stable growth rate and others for which the expectation, at least, is that growth will last for some period into the future. We can value the operating assets of a firm by discounting cashflows before debt payments, but after reinvestments, at the cost of capital. Adding the value of cash and non-operating assets give us firm value, and subtracting out debt yields the value of equity. We can also value equity directly by discounting cash flows after debt payments and reinvestment needs at the cost of equity.

42 Kaplan and Ruback (1995) examine valuations in acquisitions and find that discounted cash flow models better explain prices paid than relative valuation models.

The other approach to valuation is relative valuation, where the value of any asset is estimated by looking at how "similar" assets are priced in the market. The key steps in this approach are defining "comparable" firms or assets and choosing a standardized measure of value (usually value as a multiple of earnings, cash flows or book value) to compare the firms. To compare multiples across companies, we have to control for differences in growth, risk and cash flows, just as we would have in discounted cash flow valuation.

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