Determining the Present Value of the future cash flows of a company is the aim of any valuation technique. Generally investors buy stocks for as they expect that the future cash flows of the company will be high. Hence how much cash flow an asset is going to generate has to be calculated in order to determine the fair price to be paid for the particular stock. Price is that numerical figure at a moment when a transaction is completed when the market is in balance. It represents a snapshot of a dynamic market. Price is generally the function of demand and supply.
Valuations are used by Fundamental Analysts, Franchise Buyers, Chartists, Information Traders, Market Timers and Efficient Marketers in different ways to suit their respective objectives. Valuations are also required in Acquisition Analysis and Corporate Finance.
Valuations take into account future cash flows. Future cash flows can only be predicted or guessed with some amount of certainty. Hence even small errors like non payment of rent, etc could lead to an error in valuations. The more certain one is about the future cash flow, the valuations are correct to that degree of certainty. Therefore valuations a definitely uncertain.
Valuations can be done by various methods and no one method is the best. Different methods have to be used under different circumstances. Valuation methods, generally, can be divided into three approaches - Discounted Cash Flow method, Relative Valuation method and Contingent Claim Valuation method. All the above if used for the same valuation an give very different end results.
The sources of uncertainties in valuations are rational and can easily be identified. For the purpose of our study for this paper, we will concentrate on the Discounted Cash Flow valuation method. This method is based on the thought that "The actual value of any asset is its present value of the expected future cash flows that it will generate." Cash Flows will be different for every asset. To transform the value of future cash flows into present value, we use a Discount Rate. For some, this Discount Rate is the function of riskiness of estimated cash flows that is the rates will be higher for riskier assets and will be lower for safer assets.
There is a difference between Equity Valuation and Company Valuation. Either on the equity stake can be valued in an organization or the entire organization can be valued. In both the methods, the future cash flows of the firm are discounted, the cash flows and discount rates taken into account are different. For an Equity Valuation, the expected cash flow to equity is discounted at the Cost of Equity while to value a company, the expected cash flow to the company is discounted at the Weighted Average Cost of Capital (WACC).
Discounted Cash Flow Method is firms that have positive cash flows which can be estimated with certain amount of reliability for the future. The method cannot be used for firms in trouble, cyclical firms, firms that have unutilized assets, firms with patents, firms which are restructuring, the ones involved in acquisitions, private firms.
The most commonly used methods by discounted cash flow in order to value companies are -
- Free Cash Flow which is discounted at the Weighted Average Cost of Capital
- Cash Flow to equity discounted at the Rate of Return on Equity that is required
- Capital Cash Flow which is discounted at the Weighted Average Cost of Capital before tax
- Adjusted Present Value
- Risk Adjusted Free Cash Flow to a firm discounted at the Rate of Return required to the Assets
- Risk Adjusted Equity Cash Flow to a firm discounted at the Rate of Return required to the Assets
- Economic Profit which is discounted at Rate of required Return to Equity
- Economic Value Added which is discounted at Weighted Average Cost of Capital