Guide To Excel For Finance: Valuation Methods

DCF
There is not a specific function to run a full discounted cash flow model in Excel, but there are a number of tools to make the exercise much more straightforward. As touched upon in the PV and FV functions on a previous page, it is first necessary to estimate either the present or future value of a security, then also estimate its future cash flows. Discounting these cash flows back by an estimated discount rate will provide a future value. Conversely, starting with a present value and cash flows can allow the user to back into the estimated future value.

In addition to the above two functions, Microsoft has an IRR function that lets you back into the discount rate, or specifically the internal rate of return, for a series of cash flows. Excel points out that this is very closely related to the PV function, meaning the same inputs are needed, such as an initial present value followed by a string of cash flows.

The below details a specific cash flow stream for an investment, starting with an initial investment of $70.


Dividend Discount Model DDM
The dividend discount model (DDM) represents another approach to estimate the value of a stock or company by discounting back its estimated future dividend rates. It is very similar to a DCF, but uses dividends instead of cash flows. A basic model can be built an only requires knowing the current dividend rate, estimated dividend growth rate, and discount rate, or required rate of return.

However, there are more complicated ways to look to estimate dividends, including at rates that change over time. Below is an example of just how complicated the exercise can become:


Residual Income Model (RIM)
Along with the DDM, the residual income model (RIM) is another specialized version of a DCF used to value a firm. In its most basic form, the RIM has an equity charge that is equal to equity capital multiplied by the cost of equity. This is subtracted from net income to get to a residual income figure, which is used in lieu of cash flow or dividends, as calculated in the DCF and DDM models. Residual income figures can easily be modeled and calculated in Excel, but there are a number of steps to get to these calculations.

Below is an example of a full RIM as created in Excel:

Name of Firm:		NewCo
Date of Valuation:		11/22/10
($ and shares in millions)
Growth Rates:
First 5 years			17.00%
Years 6 – 10			11.00%
After 10 years			4.00%
Capital Retention Rates:
First 5 years			85.00%
Years 6 – 10			60.00%
After 10 years			20.00%
Past Year Normalized Earnings			$ 3,688
Beginning Book Value of Equity			$ 20,119
Expected Rate of Return on Equity			10.00%
Discount Rate			10.00%

And below are the outputs, as calculated by the above RIM:

Book Value	Present Value of
of Equity	Residual Earnings	Intrinsic Value	IV per Share
$ 20,119	$66,090	$ 86,209	$ 37

Bond Valuation
There are a number of bond valuation functions in Excel. The "PRICE" function returns the estimated market value of a bond with a $100 face value. Below are the details of the metrics needed to value such a bond, which happens to be $90.20, based on the inputs provided.



Other bond functions include the ability to calculate a bond's duration, modified duration, yield to maturity, yield, and discount rate.Basically, there is the ability to solve for any variable when valuing a bond.