Equity Valuation: Models from Leading Investment Banks

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Introduction

The goal of this book is to explain to our readers how portfolio managers and financial analysts at leading investment banks analyze companies. The models presented in this book are all rooted in the present value framework for equity valuation pioneered by Merton Miller and Franco Modigliani in the early 1960's.¹

In this final Part we discuss the underlying theory of valuation models from a theoretical perspective. Models are based on simplifying assumptions. In our opinion, a good understanding of the underlying assumptions of a valuation model can help investors avoid costly mistakes when interpreting its results. A good valuation model is simple and helps investors to make informed decisions in a complex and uncertain world. Simplicity, applicability and costs are important criteria for practitioners constructing and applying valuation models. A valuation model should be simple (but not too simple) so that the user can easily understand it, estimate its input parameters, as well as interpret and communicate its results. The benefits of a model must be weighed against the costs related to it. Anyone applying valuation models in practice should be aware of possible theoretical shortcomings and should be familiar with alternatives. It is then up to the user to decide whether to accept a valuation model or to reject it in favor of a more sophisticated approach – at the disadvantage of losing its simplicity, applicability and of higher costs.

The value of a firm ...