Givi Lemonjava
PhD in Economics
The University of Georgia
Associated Professor
Tbilisi, Georgia
Givi Lemonjava
PhD in Economics
The University of Georgia
Associated Professor
Tbilisi, Georgia
Business Valuation Modeling
Abstract
A business valuation is the process of determining the economic value of a business. During the valuation process, all parties of a business are considered to determine its worth. The business valuation process determines the current value of a business, investment or an asset, using objective measures, and evaluating all aspects of the business. Valuation is an important exercise since it can help identify mispriced securities or determine what projects a company should invest. Some of the main reasons for performing a valuation are: buying or selling a business; strategic planning; Capital financing; and Securities investing.
When valuing a company as a going concern, there are three main valuation techniques used by industry practitioners: (1) DCF analysis, (2) comparable company analysis, and (3) precedent transactions. Market approach(public company comparables or precedent transactions) , income approach(discounted free cash flow (DFCF) or residual income ) and assets approach(replacement cost or cost to build) - these are the most common methods of valuation used in investment banking, equity research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO), and most areas of finance.
This paper presents an overview of DCF models and the parameters included in it, which determine the accuracy of the assessment of the models. There are: the cash flow (CF), discount rate (r), and the number of periods (n) within the valuation timeframe. There are discussed three ways to use this model: 1) dividends discount model (DDM); 2) free cash flow to equity (FCFE ) discount model; and 3) free cash flow to the firm (FCFF ). It estimates a company’s intrinsic value which is based on a company’s ability to generate cash flow. According to this model, the value of company is function of its future cash flow, weighted average cost of capital(WACC) and growth rate (g).
The value of firm’s any operating asset/investment is equal to the present value of its expected future economic benefit stream. The reliability of these benefit streams is different from asset to asset and from entity to entity. The risk accompanies benefit streams is assessed and measured as a “cost of capital”. We have used two methods to calculate the cash flows generated by business: one – unlevered cash flow and second – levered cash flow. The first ignores capital structure and makes companies comparable; the second calculates the money that is left to shareholders after all non-equity related claims have been removed.
The analyst/appraiser faced with the task of valuing a firm/asset or its equity has three different approaches: 1) discounted cash flow valuation, 2) relative valuation, and 3) option pricing models. Within each of these approaches, there are different models. This choice must be driven largely by the characteristics of the firm/asset being valued—the level of its earnings, its growth potential, the sources of earnings growth, the stability of its leverage, and its dividend policy. Matching the valuation model to the asset or firm being valued is as important part of valuation and its output will largely depend both on this and on how correct is the input data.
Keywords: business valuation, DCF analysis, discounted free cash flow (DFCF), dividend discount model (DDM), free cash to equity (FCFE), free cash to firm (FCFF), cost of capital, and weighted average cost of capital (WACC).