Valuation approaches

In general several different approaches to valuation can be applied (figure 15). The different approaches are all applied in finance today but some of them are more used than others.

In this valuation two of the below models will be applied - the discounted cash flow to firm model and the residual income model. Both models will be focused on in the valuation as a sort of verification of the validity of the valuation.

Figure 15 - Valuation approaches

Source: Petersen & Plenborg, own creation

The DCF model is the most used model today but it is believed that the excess return approaches such as the RI model is gaining ground, because the RI model more explicitly expresses the true economic value added in a company. The big difference between the two models is that the DCF model is based on discounting the expected future cash flow and the RI model is based on accrual accounting data.

5.1.1 The discounted cash flow model

The discounted cash flow model comes in a number of different approaches. In this thesis I have chosen to apply the discounted cash flow to firm model that uses the operating cash flows of the enterprise to do the valuation. The model can be specified as follows

As seen from the illustration below the DCF-model is a two-stage model. The first stage of the model discounts the cash flows in a chosen forecasting period using the WACC as the discount factor.

Valuation approaches

Present value

Enterprise value

Discounted cash flow (to

firm) model

Economic value added

model

Adjusted present value

model

Equity value

Discounted cash flow (to

eq.) model

Residual income model

Dividend discount model

Relative valuation (Multiples)

Enterprise value (EV)

EV/IC

NOPAT  EV/

EV/EBIT

EV/EBITDA

EV/Revenue

Equity value

P/B

P/E

Liquidation

Orderly liquidation

Distress liquidation

Contingent claim valuation

Figure 16 - The discounted cash flow to firm model

Enterprise value0 = ∑ (FCFFt /(1 + WACC)^t )+ (FCFFn+1 /(WACC - g)) x (1 / 1 + WACC)ⁿ where,

FCFF = Free Cash Flow to Firm

WACC = Weighted Average Cost of Capital g = constant growth rate

n = number of years in forecast horizon t = time period

Source: Own creation

The second stage of the model discounts the infinite cash flow after the forecasting period. The WACC is also applied as the discount factor in the second stage of the model but instead of applying an explicit growth rate for each year, a constant growth rate, g, is applied when discounting the infinite cash flows. The effect from having two stages in the model is that any abnormal growth rates or special situations in the forecasting period will be capped by having a long-term stable growth rate. This is also reflected in the relation between the discounted cash flows of the forecasting period and the discounted cash flows of the terminal period, where the latter makes up for about 79,35% of the total discounted future cash flows.

The model implies that the valuation of the company is influenced by the free cash flow to firm and the WACC. The discounting of cash flows results in an enterprise value. Therefore we need to deduct the net interest bearing debt from the enterprise value before we get the market value of the company.

5.1.2 The residual income model

The residual income model (RI) is an excess return model that measures the value of equity and not the enterprise value as the discounted cash flow model does. The main difference in the model is that the RI model is based on accrual accounting data whereas the discounted cash flow model is based on cash flow data. The RI model can be specified as a two-stage model as follows:

Figure 17 - The residual income model

Market value of equity0 = Book value of equity0 + ∑ (RIt /(1+WACC)^t )+(RIn+1 /(WACC-g)) x (1/(1+WACC)ⁿ)

where,

RIt = Residual income (Net earnings - (WACC x Equityt-1)) WACC = Weighted Average Cost of Capital

g = growth rate

n = number of years in forecast horizon t = time period

Source: own creation

The two stage model consists of the three parts that can be divided in to three time frames:

current time, forecasting period and the terminal period that covers infinite fiscal years. The first part of the model is the current book value of equity. The second part of the model covers the residual income in the forecasting period discounted with WACC and the third part is the discounted residual income in the terminal period.

As in the DCF model the two stage model makes the valuation less vulnerable to abnormalities in the accounting numbers in the forecasting period because the long-term stable level makes up for 84,02% of the discounted future residual income. This calculation will end up giving the discounted residual income that reflects the market value of equity.

As this model values the market value of equity the net interest bearing debt should not be deducted from the discounted result.

The model implies that the valuation of the company is affected by net earnings, the value of equity and WACC. From the model it is obvious that the model is an excess return model as RI is only positive when the net earnings are higher than the value of equity multiplied by WACC. This makes good sense.