Overview of types of Valuation Models

The lesson discusses capital structure of companies for calculating weighted average cost of capital. The course outlines different valuation models: – relative valuation, adjusted present value, DCF Discount cash flow model, asset backed valuation model and options-based model.

Options Based Pricing

Contingent claim valuation to value assets with option like categories

Used to value certain alternatives example traded financial assets warrants, derivatives

Real assets like patents, projects, infrastructure

Options based model are used to value real assets and options and futures. This course is not designed to discuss option-based models.

Adjusted Present Value

Adjusted present value values the firm as an all equity with financing of debt. The method separates debt financing from assets of a business.

APV= Value of company with 100% equity financing + Present value of tax benefits of debt – expected bankruptcy cost  

The course focusses more on understanding discount cash flow model especially the free cash flow model.

DCF Discount Cash Flow Model

The most important ,method of valuing asset either debt or equity. Its imperative to have a basic understanding of present value of cash flows before we discuss this method in detail. Valuation of bonds takes place by valuing the cash flows of the bond during its tenure. This course is focussed towards equity valuation, the fixed income valuation will be limited.  

• Fundamental valuation of an asset to estimate intrinsic value

• Using free cash flow model to estimate the value

An example of calculating the present value of an investment. A better way to understand the present value of money is to consider the option to have ten units of a currency today or the chance to have it after six months. For this example, consider the country has moderate inflation because in a deflationary scenario, as inflation is less than zero, the value of money increases over time. These are sporadic conditions. In an inflationary situation, the value of money erodes over time. The erosion of capital is directly linked to the discount factor of inflation.

If the value of an investment is going to be 125 next year growing at the rate of 5 percent,  what was the value of the investment now.

FV= PV(1+r)^n                                           where  FV=125

125=PV (1.05)  here n=1

PV= 125/1.05= 119.05

In the above figure, consider the discount factor to be 5 percent. Consider periods 1,2,3 and 4 from 1 to 4 years. The present value column lists the present value of 100 1 to 4 years from today. The value of 100 next year would be 95.24 today. Present Value = 100/ (1.05)^2 = 90.70. The present value of 100 three years from now will be 100/(1.05)^3 = 86.38

Relative Valuation 

Using peer valuation based on comparable industry, cash flows, earnings, book value etc. This type of valuation is important to understand peer valuation of companies within the same sector. 

P/E: Price/EPS Ratio

EPS = Earnings per share 

P/E = Market price of the security/ Earnings per share

The course focuses more on understanding discount cash flow model, especially the free cash flow model.