In
intrinsic valuation, the value of an asset is estimated based upon its cash
flows, growth potential and risk. In its most common form, we use the
discounted cash flow approach to estimate intrinsic value, and the present
value of the expected cashflows on the asset, discounted back at a rate that
reflects the riskiness of these cashflows. In discounted cash flow valuation,
we begin with a simple proposition. The value of an asset is not what someone
perceives it to be worth but it is a function of the expected cash flows on
that asset. Put simply, assets with high and predictable cash flows should have
higher values than assets with low and volatile cash flows. In discounted cash
flow valuation, we estimate the value of an asset as the present value of the
expected cash flows on it.

where,

n = Life of the asset

E(CFt) = Expected cashflow in period t

r = Discount rate reflecting the riskiness of the estimated
cashflows

The
cashflows will vary from asset to asset -- dividends for stocks, coupons
(interest) and the face value for bonds and after-tax cashflows for a business.
The discount rate will be a function of the riskiness of the estimated
cashflows, with higher rates for riskier assets and lower rates for safer ones.

Using
discounted cash flow models is in some sense an act of faith. We believe that
every asset has an intrinsic value and we try to estimate that intrinsic value
by looking at an assetÕs fundamentals. What is intrinsic value? Consider it the
value that would be attached to an asset by an all-knowing analyst with access
to all information available right now and a perfect valuation model. No such
analyst exists, of course, but we all aspire to be as close as we can to this
perfect analyst. The problem lies in the fact that none of us ever gets to see
what the true intrinsic value of an asset is and we therefore have no way of
knowing whether our discounted cash flow valuations are close to the mark or not.

There
are three distinct ways in which we can categorize discounted cash flow models.
In the first, we differentiate between valuing a business as a going concern as
opposed to a collection of assets. In the second, we draw a distinction between
valuing the equity in a business and valuing the business itself. In the third,
we lay out three different and equivalent ways of doing discounted cash flow
valuation – the expected cash flow approach, a
value based upon excess returns and adjusted present value.

The
value of an asset in the discounted cash flow framework is the present value of
the expected cash flows on that asset. Extending this proposition to valuing a
business, it can be argued that the value of a business is the sum of the
values of the individual assets owned by the business.
While this may be technically right, there is a key difference between valuing
a collection of assets and a business. A business or a company is an on-going
entity with assets that it already owns and assets it expects to invest in the
future. This can be best seen when we look at the financial balance sheet (as
opposed to an accounting balance sheet) for an ongoing company in figure 1.1:

Note
that investments that have already been made are categorized as assets in
place, but investments that we expect the business to make in the future are
growth assets.

A
financial balance sheet provides a good framework to draw out the differences
between valuing a business as a going concern and valuing it as a collection of
assets. In a going concern valuation, we have to make our best judgments not
only on existing investments but also on expected future investments and their
profitability. While this may seem to be foolhardy, a large proportion of the
market value of growth companies comes from their growth assets. In an
asset-based valuation, we focus primarily on the assets in place and estimate
the value of each asset separately. Adding the asset values together yields the
value of the business. For companies with lucrative growth opportunities,
asset-based valuations will yield lower values than going concern valuations.

One
special case of asset-based valuation is liquidation valuation, where we value
assets based upon the presumption that they have to be sold now. In theory,
this should be equal to the value obtained from discounted cash flow valuations
of individual assets but the urgency associated with liquidating assets quickly
may result in a discount on the value. How large the discount will be will
depend upon the number of potential buyers for the assets, the asset
characteristics and the state of the economy.

There are two ways in which we can
approach discounted cash flow valuation. The first is to value the entire
business, with both assets-in-place and growth assets; this is often termed
firm or enterprise valuation.

The cash flows before debt payments and after reinvestment needs are called __free
cash flows to the firm__, and the discount rate that reflects the composite
cost of financing from all sources of capital is called the __cost of capital__.

The second way is to just value the
equity stake in the business, and this is called equity valuation.

The cash flows after debt payments and reinvestment needs are called free cash
flows to equity, and the discount rate that reflects just the cost of equity
financing is the cost of equity.

Note
also that we can always get from the former (firm value) to the latter (equity
value) by netting out the value of all non-equity claims from firm value. Done
right, the value of equity should be the same whether it is valued directly (by
discounting cash flows to equity a the cost of equity) or indirectly (by
valuing the firm and subtracting out the value of all non-equity claims). We
will return to discuss this proposition in far more detail in a later chapter.

The
model that we have presented in this section, where expected cash flows are
discounted back at a risk-adjusted discount rate, is the most commonly used
discounted cash flow approach but there are two widely used variants. In the
first, we separate the cash flows into excess return cash flows and normal
return cash flows. Earning the risk-adjusted required return (cost of capital
or equity) is considered a normal return cash flow but any cash flows above or
below this number are categorized as excess returns; excess returns can
therefore be either positive or negative. With the *excess return valuation* framework, the value of a business can be
written as the sum of two components:

Value of business = Capital
Invested in firm today + Present value of excess return cash flows from both
existing and future projects

If
we make the assumption that the accounting measure of capital invested (book
value of capital) is a good measure of capital invested in assets today, this
approach implies that firms that earn positive excess return cash flows will
trade at market values higher than their book values and that the reverse will
be true for firms that earn negative excess return cash flows.

In
the second variation, called the *adjusted
present value (APV) approach*, we separate the effects on value of debt
financing from the value of the assets of a business. In general, using debt to
fund a firmÕs operations creates tax benefits (because interest expenses are
tax deductible) on the plus side and increases bankruptcy risk (and expected
bankruptcy costs) on the minus side. In the APV approach, the value of a firm
can be written as follows:

Value of business = Value of
business with 100% equity financing + Present value of Expected Tax Benefits of
Debt – Expected Bankruptcy Costs

In
contrast to the conventional approach, where the effects of debt financing are
captured in the discount rate, the APV approach attempts to estimate the
expected dollar value of debt benefits and costs separately from the value of
the operating assets.

While
proponents of each approach like to claim that their approach is the best and
most precise, we will show later in the book that the three approaches yield
the same estimates of value, if we make consistent assumptions.

* *While
the focus in classrooms and academic discussions remains on discounted cash
flow valuation, the reality is that most assets are valued on a relative basis.
In relative valuation, we value an asset by looking at how the market prices
similar assets. Thus, when determining what to pay for a house, we look at what
similar houses in the neighborhood sold for rather than doing an intrinsic
valuation. Extending this analogy to stocks, investors often decide whether a
stock is cheap or expensive by comparing its pricing
to that of similar stocks (usually in its peer group). In this section, we will
consider the basis for relative valuation, ways in which it can be used and its
advantages and disadvantages.

In
relative valuation, the value of an asset is derived from the pricing of
'comparable' assets, standardized using a common variable. Included in this
description are two key components of relative valuation. The first is the
notion of __comparable or similar__ assets. From a valuation standpoint,
this would imply assets with similar cash flows, risk and growth potential. In
practice, it is usually taken to mean other companies that are in the same
business as the company being valued. The other is a __standardized price__.
After all, the price per share of a company is in some sense arbitrary since it
is a function of the number of shares outstanding; a two for one stock split
would halve the price. Dividing the price or market value by some measure that
is related to that value will yield a standardized price. When valuing stocks,
this essentially translates into using multiples where we divide the market
value by earnings, book value or revenues to arrive at an estimate of
standardized value. We can then compare these numbers across companies.

The
simplest and most direct applications of relative valuations are with real
assets where it is easy to find similar assets or even identical ones. The
asking price for a Mickey Mantle rookie baseball card or a 1965 Ford Mustang is
relatively easy to estimate given that there are other Mickey Mantle cards and
1965 Ford Mustangs out there and that the prices at which they have been bought
and sold can be obtained. With equity valuation, relative valuation becomes
more complicated by two realities. The first is the absence of similar assets,
requiring us to stretch the definition of comparable to include companies that
are different from the one that we are valuing. After all, what company in the
world is remotely similar to Microsoft or GE? The other is that different ways
of standardizing prices (different multiples) can yield different values for
the same company.

Harking
back to our earlier discussion of discounted cash flow valuation, we argued
that discounted cash flow valuation was a search (albeit unfulfilled) for
intrinsic value. In relative valuation, we have given up on estimating
intrinsic value and essentially put our trust in markets getting it right, at
least on average.

In
relative valuation, the value of an asset is based upon how similar assets are
priced. In practice, there are three variations on relative valuation, with the
differences primarily in how we define comparable firms and control for
differences across firms:

a. *Direct comparison*: In this approach,
analysts try to find one or two companies that look almost exactly like the
company they are trying to value and estimate the value based upon how these
ÒsimilarÓ companies are priced. The key part in this analysis is identifying
these similar companies and getting their market values.

*b*. *Peer
Group Average*: In the second, analysts compare how their company is priced
(using a multiple) with how the peer group is priced (using the average for
that multiple). Thus, a stock is considered cheap if it trade at 12 times
earnings and the average price earnings ratio for the sector is 15. Implicit in
this approach is the assumption that while companies may vary widely across a
sector, the average for the sector is representative for a typical company.

*c. Peer group average adjusted for
differences*: Recognizing that there can be wide differences between the
company being valued and other companies in the comparable firm group, analysts
sometimes try to control for differences between companies. In many cases, the
control is subjective: a company with higher expected growth than the industry
will trade at a higher multiple of earnings than the industry average but how
much higher is left unspecified. In a few cases, analysts explicitly try to
control for differences between companies by either adjusting the multiple
being used or by using statistical techniques. As an example of the former,
consider PEG ratios. These ratios are computed by dividing PE ratios by
expected growth rates, thus controlling (at least in theory) for differences in
growth and allowing analysts to compare companies with different growth rates.
For statistical controls, we can use a multiple regression where we can regress
the multiple that we are using against the fundamentals that we believe cause
that multiple to vary across companies. The resulting regression can be used to
estimate the value of an individual company. In fact, we will argue later in this
book that statistical techniques are powerful enough to allow us to expand the
comparable firm sample to include the entire market.