Valuation Principles And Practice

In this chapter, we look at how to value a firm and its equity, given what we now know about investment, financing and dividend decisions. We will consider two approaches to valuation. The first and most fundamental approach to valuing a firm is discounted cash flow valuation, which extends the present value principles that we developed to analyze projects to value a firm. The value of any firm is determined by four factors - its capacity to generate cash flows from assets in place, the expected growth rate of these cash flows, the length of time it will take for the firm to reach stable growth, and the cost of capital. Consequently, to increase the value of a firm, we have to change one or more of these variables.

The second way of valuing a firm or its equity is to based the value on how the market is valuing similar or comparable firms; this approach is called relative valuation. This approach can yield values that are different from a discounted cashflow valuation and we will look at some of the reasons why these differences may occur.

In a departure from the previous chapters, we will take the perspective of investors in financial markets in estimating value. Investors assess the value of a firm's stock in order to decide whether to buy the stock or, if they already own it, whether to continue to it.

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