Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

SUMMARY

This chapter offers five lessons. First, in picking a comparable company for use in multiple-based valuation, the choice is dependent to a large extent on the choice of multiple. For example, the choice of a comparable for a valuation based on P/B should depend on ROE, and the comparable for a valuation based on P/S should depend on PM.

Second, much better results can be obtained if we use a warranted-multiple approach to select peer companies. In this approach, we start with the industry mean and adjust for PM, expected growth, and R&D. Because this approach is based on a DCF valuation model, we are able to find matching companies that have the closest overall match to the target company for valuation purposes.

Third, the warranted-multiple approach is applicable in cross-border situations. We are now taking the same approach to valuation using a pool of companies from the G–7 countries. Our preliminary findings suggest this technique works well in an international setting.

Fourth, an integration of relative and direct valuation techniques is possible when peers are chosen based on warranted multiples. The line between the two techniques has been blurred through the use of “smart” multiples. The “smart” comes from using DCF concepts to pick peers.

Fifth, RIMs and DCF models are similar in spirit. Their goal is the same, and with specific international applications, they allow for cross-border comparables.