Approaches to Valuation

Analysts use a wide spectrum of models, ranging from the simple to the sophisticated. These models often make very different assumptions about the fundamentals that determine value, but they do share some common characteristics and can be classified in broader terms. There are several advantages to such a classification -- it makes it is easier to understand where individual models fit in to the big picture, why
they provide different results and when they have fundamental errors in logic. In general terms, there are three approaches to valuation. The first, discounted  cash flow valuation, relates the value of an asset to the present value of expected future cash flows on that asset. The second, relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cash flows, book value or sales. The third, contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics. While they can yield different estimates of value, one of the objectives of this book is to explain the reasons for such differences, and to help in picking the right model to use for a specific task.


Discounted Cash-flow Valuation

In discounted cash flows valuation, the value of an asset is the present value of the expected cash flows on the asset, discounted back at a rate that reflects the riskiness of these cash flows. This approach gets the most play in classrooms and comes with the best theoretical credentials. In this section, we will look at the foundations of the approach and some of the preliminary details on how we estimate its inputs.

Basis for Approach
We buy most assets because we expect them to generate cash flows for us in the future. In discounted cash flow valuation, we begin with a simple proposition. The value of an asset is not what someone perceives it to be worth but it is a function of the expected cash flows on that asset. Put simply, assets with high and predictable cash flows should have higher values than assets with low and volatile cash flows. In discounted
cash flow valuation, we estimate the value of an asset as the present value of the expected cash flows on it.

The cash flows will vary from asset to asset -- dividends for stocks, coupons(interest) and the face value for bonds and after-tax cash flows for a business. The discount rate will be a function of the riskiness of the estimated cash flows, with higher rates for riskier assets and lower rates for safer ones.Using discounted cash flow models is in some sense an act of faith. We believe that every asset has an intrinsic value and we try to estimate that intrinsic value by looking at an asset’s fundamentals. What is intrinsic value? Consider it the value that would be attached to an asset by an all-knowing analyst with access to all information available right now and a perfect valuation model. No such analyst exists, of course, but we all aspire to be as close as we can to this perfect analyst. The problem lies in the fact that none of us ever gets to see what the true intrinsic value of an asset is and we therefore have no way of knowing whether our discounted cash flow valuations are close to the mark or not.