Reconciling Different Valuations

The two approaches to valuation - discounted cash flow valuation and relative valuation - yield different values for Disney42. In fact, Disney is significantly overvalued using a discounted cashflow model but is closer to being fairly valued using relative valuation models. Even within relative valuation, we arrive at different estimates of value, depending upon which multiple we use and what firms we based the relative valuation on.

The differences in value between discounted cash flow valuation and relative valuation come from different views of market efficiency, or put more precisely, market inefficiency. In discounted cash flow valuation, we assume that markets make mistakes, that they correct these mistakes over time, and that these mistakes can often occur across entire sectors or even the entire market. In relative valuation, we assume that while markets make mistakes on individual stocks, they are correct on average. In other words, when we value Disney relative to other entertainment companies, we are assuming that the market has priced these companies correctly, on average, even though it might have made mistakes in the pricing of each of them individually. Thus, a stock may be over valued on a discounted cash flow basis but under valued on a relative basis, if the firms used in the relative valuation are all overpriced by the market. The reverse would occur, if an entire sector or market were underpriced.

To conclude, we suggest the following broad guidelines on gauging value using different approaches:

• The discounted cash flow models are built on the implicit assumption of long time horizons, giving markets time to correct their errors.

• When using relative valuation, it is dangerous to base valuations on multiples where the differences across firms cannot be explained well using financial fundamentals - growth, risk, and cash flow patterns. One of the advantages of using the regression approach described in the later part of this chapter is that the R-squared and t-statistics from the regressions yield a tangible estimate of the strength (or weakness) of this relationship.

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