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