Equity Valuation

What is the going concern assumption?

The assumption that a company will continue operating as a business, rather than going out of business. It's the foundation for most valuation models.

What is liquidation value?

An estimate of what a firm's assets would bring if sold separately, net of the company's liabilities — used when the going concern assumption doesn't hold.

What is orderly liquidation value?

The value of a firm's assets if sold over time, allowing for better prices than a forced/immediate sale.

Porter 5 forces

1. Threat of new entrants in the industry.

2. Threat of substitutes.

3. Bargaining power of buyers.

4. Bargaining power of suppliers.

5. Rivalry among existing competitors.

What is an absolute valuation model, and what are its three main approaches?

A model that estimates intrinsic value based on a firm's own investment characteristics, without reference to other firms. Approaches: dividend discount models, free cash flow / residual income models, and asset-based models.

What's the difference between dividend discount models and free cash flow (or residual income) models?

DDM values equity as the present value of expected dividends. FCF/residual income models expand this to all cash flow available to equity holders (not just what's paid out) — cash left after senior claims like bondholders and taxing authorities are satisfied.

What is a relative valuation model, and how is "relatively overvalued" different from "overvalued"?

A relative model values an asset by comparing it to other assets, typically via a multiple like P/E. A high P/E vs. peers means relatively overvalued (overvalued compared to comparables) — not necessarily overvalued on an intrinsic (absolute) basis.

What is sum-of-the-parts (breakup/private market) valuation, and when is it especially useful?

Valuing a company by valuing its individual divisions or product lines separately, then adding them up. It's especially useful for conglomerates with multiple divisions that have different business models and risk characteristics.

What is conglomerate discount?

The amount by which a conglomerate's market value falls short of its sum-of-the-parts value — reflecting the markdown investors apply to companies operating in multiple unrelated industries vs. single-industry-focused firms.

1) Internal capital inefficiency (poor capital allocation across divisions),

2) Endogenous factors (e.g., unrelated acquisitions to mask weak performance),

3) Research measurement errors (the discount may not really exist, just be mismeasured).

What are the pros and cons of using residual income as the cash flow measure in a valuation model?

1. Theoretically grounded in opportunity cost — the required return represents what capital suppliers give up by investing here rather than elsewhere; residual income captures only the earnings generated above that opportunity cost.

2. Works where DDM and FCF models struggle — applicable to firms with negative free cash flow, and to both dividend-paying and non-dividend-paying firms.

Cons:

1. Sensitive to accounting quality — requires deep analysis of accruals, and management discretion over income/expense recognition can distort the true economic picture. Poor transparency or low earnings quality makes residual income unreliable to estimate.

When residual income models ARE appropriate:

• No dividend history

• Negative free cash flow expected for the foreseeable future (often due to heavy capital demands)

• Transparent financial reporting and high-quality earnings

What are the pros and cons of using dividends as the cash flow measure in a valuation model?

Pros:

1. Theoretically justified — a shareholder's investment is ultimately worth the present value of the dividends they'll receive (directly, or indirectly via the price a buyer pays, which itself reflects future expected dividends).

2. Less volatile than earnings or FCF, so value estimates are more stable and better reflect long-term earning power rather than short-term noise.

Cons:

1. Hard to apply to non-dividend payers — you'd have to forecast when dividends will start, which compounds uncertainty across earnings, payout ratio, growth, and required return far into the future.

2. Minority-shareholder perspective only — assumes you can't influence dividend policy. If dividend policy isn't tied to the firm's actual profitability/value creation (e.g., controlling shareholders withhold or overpay dividends for reasons unrelated to earnings power), dividends stop being a reliable cash flow proxy.

When dividends ARE appropriate: company has a dividend history, payout policy is clear and linked to earnings, and you're valuing from a minority shareholder's perspective — most common for mature-stage firms.

What are the pros and cons of using free cash flow (FCFF/FCFE) as the cash flow measure in a valuation model?

Pros:

1. Broadly applicable — works regardless of a firm's dividend policy or capital structure, unlike DDMs which need an actual (or forecastable) dividend stream.

2. Relevant to controlling shareholders — a controlling stake can decide how free cash flow is distributed or reinvested, so FCF speaks directly to that perspective.

3. Still useful to minority shareholders — because a firm can be acquired at a price reflecting its value to a controlling party, so FCF-based value is relevant even to a minority holder indirectly.

Cons:

1. Unreliable for capital-intensive firms — heavy ongoing capital requirements (e.g., a technological shift forcing continuous reinvestment, or rapid expansion into new markets) can produce negative FCF for many years, making forecasts harder to build and less reliable.

When FCF models ARE appropriate:

• No dividend history, or dividends aren't clearly tied to earnings

• Free cash flow tracks the firm's profitability reasonably well

• Valuation perspective is that of a controlling shareholder

Why use spreadsheets over stylized valuation models (DDM, H-model, etc.)?

Real dividends rarely grow smoothly or in just 2–3 stages, and one-off events don't fit standard patterns. Spreadsheets flexibly model any cash flow pattern over any horizon (10–20+ yrs), which stylized formulas can't handle.

What are the 4 steps of a spreadsheet dividend valuation model?

1) Set base dividend (last year's actual or normalized).
2) Forecast dividends through the supernormal growth period.
3) Estimate terminal value using a stable long-term growth rate at the end of that period.
4) Discount all dividends + terminal value to present value.

How does terminal value differ in a spreadsheet vs. a standard DDM?

A spreadsheet valuation is a dividend/cash-flow valuation built directly in a spreadsheet rather than plugged into a closed-form formula (like Gordon growth or a two-stage DDM). It follows the same 4-step logic — base dividend, forecast the growth period, estimate terminal value, discount to present value — but lets you customize each year's cash flow individually and run scenario analysis, rather than forcing growth into a fixed 1-, 2-, or 3-stage pattern.

What is firm value and how is it calculated?

Firm value = PV of expected future FCFF discounted at the WACC. (Technically this equals the value of operating assets; add excess cash, excess marketable securities, or land held for investment if specified to get total firm value.)

What is equity value and how is it calculated (two ways)?

Equity value = PV of expected future FCFE discounted at the required return on equity. Alternatively: equity value = firm value − market value of debt.

What's the most common mistake in FCFF/FCFE valuation, and how do you avoid it?

Mismatching cash flow and discount rate. Always discount FCFF at the WACC (→ firm value); always discount FCFE at the required return on equity (→ equity value).

When should you use FCFF vs. FCFE for equity valuation?

: Use FCFE directly when capital structure is relatively stable. Use FCFF (then subtract market value of debt) when FCFE is negative or the company carries significant/volatile debt — this indirect approach still yields equity value.

What is the APV approach, and when is it used instead of standard WACC-based valuation?

APV (adjusted present value) is used when a firm's capital structure is volatile. It discounts the firm's unlevered cash flows (assuming no leverage effect) at the unlevered cost of equity, then adds the NPV of debt (value of the tax shield minus cost of financial distress) to get total firm value.

What ownership perspective does the free cash flow approach assume, vs. the dividend discount model (DDM)?

FCF approach assumes a control perspective (an acquirer who can change dividend policy) or minority shareholders of a takeover target. DDM assumes a minority owner perspective with no control over dividend policy. If investors pay a premium for control, FCF and DDM values can differ.

Why do analysts often prefer FCF valuation over dividend-based valuation? (4 reasons)

(1) Many firms pay no/low dividends;

(2) dividends are set at the board's discretion and may not align with long-run profitability;

(3) FCF better suits acquisition targets since new owners control distributions (control perspective);

(4) FCF is more closely tied to the firm's long-run profitability than dividends are.

What stage model is best for industry with significant barriers to entry.

2 stage

What are the advantages and disadvantages of using the Price-to-Book (P/B) ratio?

Advantages:

1. Book value is almost always positive (unlike EPS), so P/B works even when P/E doesn't (e.g., firm reports a loss).

2. Book value is more stable than EPS, making P/B useful when earnings are volatile or extreme.

3. Book value approximates net asset value well for firms holding mostly liquid assets (banks, insurers, finance/investment companies).

4. Useful for valuing firms expected to go out of business (liquidation value).

5. Empirical research shows P/B helps explain differences in long-run average stock returns.

Disadvantages:

1. Ignores intangible assets like human capital.

2. Distorted by differences in asset size across firms — e.g., a firm that outsources production has fewer assets, lower book value, and higher P/B than a similar firm that doesn't.

3. Differing accounting conventions (e.g., R&D expensed in the U.S.) obscure true shareholder investment, hurting cross-firm/cross-country comparability.

4. Inflation and technological change can cause book value to diverge from market value, further distorting comparisons.

What are the advantages and disadvantages of using the Price-to-Sales (P/S) ratio?

Advantages:

1. Meaningful even for distressed firms — sales revenue is almost always positive, unlike earnings (P/E) or book value (P/B), which can turn negative.

2. Sales revenue is harder to manipulate or distort than EPS or book value, which are more sensitive to accounting choices.

3. Less volatile than P/E, making it more reliable when a given year's earnings are unusually high or low relative to the long-run trend.

4. Especially useful for: mature/cyclical industries, start-ups with no earnings history, and investment management companies/partnerships.

5. Like P/E and P/B, empirical research links differences in P/S to differences in long-run average stock returns.

Disadvantages:

1. High sales growth doesn't guarantee high operating profits or cash flow.

2. Doesn't account for differences in cost structures between companies.

3. Still vulnerable to revenue recognition distortions — e.g., bill-and-hold sales (selling now, delivering later) can pull revenue into an earlier period and inflate the ratio's usefulness artificially.

What are the advantages and disadvantages of using the Price-to-Cash Flow (P/CF) ratio?

Advantages:

1. Cash flow is harder for managers to manipulate than earnings.

2. P/CF is more stable than P/E.

3. Using cash flow instead of earnings sidesteps issues with earnings quality — a common problem for P/E.

4. Empirical research shows differences in P/CF are significantly related to differences in long-run average stock returns.

Disadvantages (both stem from how "cash flow" is defined):

1. The simple EPS-plus-noncash-charges estimate ignores items that actually affect operating cash flow, such as noncash revenue and net changes in working capital.

2. Theoretically, free cash flow to equity (FCFE) is a better measure than operating cash flow — but FCFE is more volatile, so it isn't necessarily more informative in practice.

What is the dividend yield (D/P) approach, and what are its advantages and disadvantages?

The ratio of the common dividend to the market price. Most often used for valuing indexes.

Advantages:

1. Dividend yield contributes directly to total investment return.

2. Dividends are less risky than the capital appreciation component of total return.

Disadvantages:

1. Incomplete measure — it ignores capital appreciation entirely.

2. Dividend displacement of earnings: dividends paid now displace future earnings, implying a trade-off between current cash flows and future cash flows.

PEG drawbacks

• The relationship between P/E and g is not linear, which makes comparisons difficult.

• The PEG ratio still doesn't account for risk.

• The PEG ratio doesn't reflect the duration of the high-growth period for a multistage valuation model, especially if the analyst uses a short-term high-growth forecast.

4 FCF defintions

(1) earnings-plus-noncash-charges (CF); (2) adjusted cash flow (adjusted CFO); (3) free cash flow to equity (FCFE); and (4) earnings before interest, taxes, depreciation, and amortization (EBITDA). Expect to see any one of them on the exam.

What are the advantages and disadvantages of using EV/EBITDA?

Advantages:

1. More useful than P/E when comparing firms with different degrees of financial leverage (since EV/EBITDA is a capital-structure-neutral measure — it looks at the whole firm, not just equity).

2. Well-suited to capital-intensive businesses with high depreciation and amortization, since EBITDA adds these back.

3. EBITDA is usually positive even when EPS is negative.

Disadvantages:

1. If working capital is growing, EBITDA overstates cash flow from operations (CFO). It also ignores how different revenue recognition policies affect CFO.

2. FCFF is more theoretically sound than EBITDA because it accounts for capital expenditures. EBITDA is only an adequate proxy when capital expenditures roughly equal depreciation expense.

Why is relative valuation using comparable firms challenging in an international context?

Because of differences across countries in:

• Accounting methods

• Culture

• Risk

• Growth opportunities

This makes benchmarking difficult since P/Es for individual firms in the same industry vary widely internationally, and even country-level market P/Es can differ significantly.

What is residual income (economic profit), and why does it matter for measuring a firm's performance?

Residual income is a firm's net income minus a charge for stockholders' opportunity cost of equity capital. It matters because traditional accounting net income only deducts the cost of debt (interest expense) and ignores the cost of equity — so a firm can show positive net income while still failing to meet equity investors' required return. Residual income corrects this by explicitly deducting all capital costs, both debt and equity, giving a truer picture of economic profitability.

What is Market Value Added (MVA), and how is it calculated?

MVA is the difference between the market value of a firm's long-term debt and equity and the book value of invested capital supplied by investors. It measures the value management has created since the firm's inception.

Formula: MVA = Market value − Total capital

Residual Income Model Strengths and Weaknesses

Strengths of residual income models include the following:

• Terminal value does not dominate the intrinsic value estimate, as is the case with dividend discount and free cash flow valuation models.

• Residual income models use accounting data, which is usually easy to find.

• The models are applicable to firms that do not pay dividends or that do not have positive expected free cash flows in the short run.

• The models are applicable even when cash flows are volatile.

• The models focus on economic profitability rather than just on accounting profitability.

Weaknesses of residual income models include the following:

• The models rely on accounting data that can be manipulated by management.

• Reliance on accounting data requires numerous and significant adjustments.

• The models assume that the clean surplus relation holds or that its failure to hold has been properly taken into account.

When is RI model appropriate and not appropriate?

Residual income models are appropriate under the following circumstances:

• A firm does not pay dividends, or the stream of payments is too volatile to be sufficiently predictable.

• Expected free cash flows are negative for the foreseeable future.

• The terminal value forecast is highly uncertain, which makes dividend discount or free cash flow models less useful.

Residual income models are not appropriate under the following circumstances:

• The clean surplus accounting relation is violated significantly.

• There is significant uncertainty concerning the estimates of book value and return on equity.

What is the clean surplus relationship, and what risk arises for the residual income model when it doesn't hold?

The clean surplus relationship states:
Ending BV = Beginning BV + Net Income − Dividends

It breaks down when certain items are charged directly to shareholders' equity, bypassing the income statement. Examples include:

• Foreign currency translation gains/losses (cumulative translation adjustment, CTA) under the current rate method

• Certain pension adjustments

• Gains/losses on certain hedging instruments

• Changes in revaluation surplus (IFRS only)

• Changes in the value of liabilities due to changes in the liability's own credit risk (IFRS only)

• Changes in market value of available-for-sale securities

Effect: Net income becomes distorted (incorrect), while book value remains correct (since it still reflects the direct equity adjustments).

Risk for the residual income model: If these violations are not expected to reverse/offset in future periods, forecasted ROE will be inaccurate — the analyst needs to adjust net income for these items.

Key exception: If the item (e.g., CTA) tends to reverse over time and isn't consistently one-directional (positive or negative), the analyst can safely forecast ROE without adjusting for it, since it will average out.

Private Company-specific factors

• Stage of life cycle: Private firms are usually less mature than public firms, though some are mature or near liquidation, so valuation must match the life cycle stage.

• Size: Private firms are typically smaller with less capital and fewer assets, making them riskier and warranting higher risk premiums/required returns.

• Quality and depth of management: Smaller private firms often attract fewer qualified managers, which can slow growth and raise risk.

• Management/shareholder overlap: Management often owns a large stake in private firms, reducing agency conflicts and supporting a longer-term perspective.

• Short-term investors: Public firm shareholders often push for short-term performance, while private firm managers (as long-term owners) tend to focus longer-term.

• Quality of financial and other information: Private firms disclose less information than public firms, increasing uncertainty, risk, and reducing valuations.

• Taxes: Private firm owners/managers are often more tax-sensitive than public firm investors.

Private Company Transaction-Related Valuations

• Venture capital financing: Development-stage firms often get private VC funding in milestone-based rounds, with valuations informal and negotiated due to cash flow uncertainty.

• IPO: Going public boosts liquidity, and investment banks typically value the firm by benchmarking against similar public companies.

• Sale in an acquisition: Firms sold for liquidity are valued by both buyer and seller, with the final price subject to negotiation.

• Bankruptcy proceedings: Accurate valuation helps determine liquidation vs. reorganization and supports restructuring if the firm continues as a going concern.

• Performance-based managerial compensation: Stock options, restricted stock, or ESOPs require accurate valuation for accounting and tax purposes.

• Debt financing: Lenders use valuation as part of their underwriting process.

Challenges with DR for Private Companies

• Size premiums: Small-firm premiums may be biased upward if the sample includes formerly larger, now-distressed firms.

• Availability and cost of debt: Private firms often have less access to (cheaper) debt, pushing their WACC higher than public firms'.

• Acquirer versus target: The target's own (higher) cost of capital should be used, not the acquirer's, or the target will be overvalued.

• Projection risk: Limited information and inexperienced management forecasting may justify a higher discount rate and subjective adjustments to earnings.

• Life cycle stage: Early-stage firms are hard to discount accurately, especially since high unsystematic risk can make CAPM inappropriate, and classifying the stage itself is difficult.

Ways to estimate DLOM

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• Method 1 (Restricted stock): Compare restricted share prices to publicly traded share prices of the same firm (e.g., under SEC Rule 144).

• Method 2 (Pre-IPO vs. post-IPO): Compare pre-IPO to post-IPO share prices, though this may overstate DLOM since post-IPO firms also have lower risk/more certain cash flows.

• Method 3 (Put option model): Estimate DLOM as an at-the-money put option value (from a comparable public firm) divided by stock price—this captures firm-specific risk but assumes a guaranteed sale price rather than true liquidity.

Method to value private companies

1. Income approach. This values a firm as the present value of its expected future income. Such valuation may be based on various different assumptions and variations.

2. Market approach. This values a firm using multiples from recent sales of comparable assets.

3. Asset-based approach. This values a firm as the value of its assets minus its liabilities.

What issues should be considered when estimating a control premium (GPCM)?

• Transaction type — Strategic buyers (synergies) pay higher premiums than financial buyers (stand-alone value)

• Industry conditions — During acquisition waves, public share prices may already embed some control premium, so adding a standard premium on top can double-count and overstate value

• Type of consideration — Stock-funded deals (vs. cash) can overstate the premium if the acquirer's shares were trading at inflated ("bubble") values

• Reasonableness — Premiums and multiples can compound into unrealistic results over time (e.g., 6x × 1.2 = 7.2 historically vs. 10x × 1.2 = 12 later) — always sanity-check the final multiple

• Multiple industries — For firms spanning industries, use a revenue-weighted average EV multiple:
  weighted average EV multiple = ∑ Wᵢ × multipleᵢ (Wᵢ = industry i's share of revenue)

• Other factors — Differences in size, country, tax status, and leverage between subject and comparable firms

What is the Guideline Transactions Method (GTM), and what issues should be considered when using it?

• Definition: Uses prior acquisition prices for entire companies; these values already include a control premium, so no additional control adjustment is needed (unlike GPCM)

• Data caveat: Private firm transaction data is less available and less reliable than public data

• Issues to check:

  • Transaction type — strategic (synergy-driven) vs. nonstrategic deals may need multiple adjustments

  • Contingent consideration — price tied to future milestones (e.g., regulatory approval) adds seller risk; scrutinize before comparing to non-contingent deals

  • Type of consideration — cash vs. stock deals may not be directly comparable

What are the income-based and market-based approaches to private company valuation?

Income-Based Approaches (value = present value of future income)

• Free Cash Flow (FCF) Method — two-stage model; forecasts discrete cash flows + a terminal value once growth stabilizes

• Capitalized Cash Flow Method (CCM) — single-stage growing perpetuity model (FCFF₁ / (WACC − g)); best for small firms with stable growth and no good comparables

• (3rd: Excess Earnings Method — values intangibles as PV of "excess" earnings above required return on working capital/fixed assets; used for small firms with significant intangibles)

Market-Based Approaches (value = multiples from comparable transactions)

• Guideline Public Company Method (GPCM) — uses multiples from public company trades; requires adding a control premium since public trades are typically noncontrolling stakes

• Guideline Transactions Method (GTM) — uses prior whole-company acquisition prices; already includes control premium, so no further adjustment needed

• (3rd: Prior Transaction Method — uses actual past transactions in the subject company's own stock)