In an equity valuation theory and practice, there are generally two valuation approaches: discounted cash flows (DCF) and comparables.

The DCF Model

The DCF model refers to a group of approaches that are also called “present value models.” These traditionally assume the value of an asset equals the present value of all future monetary benefits. This model is easy to use when the future cash benefits are known or can be at least reasonably forecasted.

Generally, a DCF model requires the following inputs:

The most common variations of the DCF model are the dividend discount model (DDM) and the free cash flow (FCF) model, which, in turn, has two forms: free cash flow to equity (FCFE) and free cash flow to firm (FCFF) models. In the DDM, future dividends represent cash flows that are discounted with a relevant required rate of return.

If companies are expected to increase dividend payouts, this must also be modeled. In addition, a constant growth rate or multiple growth rates representing long-term and short-term growth rates are added to the model.


Advantages



Disadvantages



Intrinsic value of an equity can be justified


Relies on free cash flows rather than accounting figures


Different variations of the model account for different growth rates (e.g., multistage models)



Based on assumptions on inputs (growth rate, required return on equity and future cash flows)


Difficult to forecast cash flows in cyclical businesses


 


The Comparables Method

The comparables method uses ratios from an industry, peer group or similar companies to estimate a company’s equity value. The following ratios are mostly used: price-to-earning ratio (P/E), price-to-sales ratio (P/S), and enterprise value-to-earnings before interest, tax, depreciation and amortization (EV/EBITDA), which are also called multiples (because of this, the comparables method is also called the “multiples method.”) The prevailing concept behind the comparable method is the law of one price, which states that similar assets should sell at a similar price. We can rephrase this for company earnings or profit: Companies that have similar revenues and earnings drivers should be worth about the same.

For example, imagine that you want to value the equity of a company that operates in office printing devices business and the trailing-12-month (TTM) earnings per share (EPS) is $0.50. If the TTM P/E ratio for this industry is 18.55x, then by multiplying company EPS by this multiple, we obtain $9.275 (0.5*18.55), which can be assumed to be the intrinsic value of the company's common stock.


Advantages



Disadvantages



Easy to understand and apply


Fewer assumptions used than with DCF


Better captures current mood of market



Choice of multiples sometimes subjective


Difficult to find comparables with identical, or at least similar, revenue drivers


Assumption that market accurately values the peer group


Which Model to Use

The choice between these two alternative valuation models will depend on specific factors, such as availability and accuracy of the inputs (revenue drivers, business cycles, etc.).

Dividend-Paying, Mature and Stable Companies

The DDM model is best applied for stable and mature public companies that pay dividends. For example, BP plc. (BP), Microsoft Corporation (MSFT) and Wal-Mart Stores, Inc. (WMT) pay regular dividends and can be characterized as stable and mature businesses. Therefore, the DDM can be applied to value these companies.

The FCF model can be used to calculate the valuation of companies that do not pay dividends or pay dividends in an irregular fashion. This model is also applied for those companies with a dividend growth rate that does not properly capture the earnings growth rates.

Companies with Diverse Revenue Drivers

When a company valued has a diversified revenue source, the free cash flow method can be a better approach than the comparable method, simply because finding a true comparison can be problematic. Today there are a number of large-cap companies with diversified revenue drivers. This feature makes it challenging to find a relevant peer group, company, or even industry multiples.

For example, both Canon Inc. (CAJ) and Hewlett-Packard Company (HPQ) are large manufacturers of printing machines for business and personal use. However, HP’s revenue also is derived from the computer business. HP and Apple are both competitors in the computer business, but Apple derives its revenue mostly from sales of smartphones and tablets.

Apparently, neither Canon and HP, nor HP and Apple, can be in a peer group in order to use a peer group multiple. 

Valuation of Private Companies

There is no straightforward choice of valuation model for private companies. It will depend on the maturation of the private company and the availability of model inputs. For a stable and mature company, the comparables method can be the best option.

In general, it is very complicated to get the inputs required for the DCF model from private companies. The beta, which is one of the key inputs for a returns estimation of a private company, is best estimated using comparable firms’ betas. This makes it challenging to apply the DCF model.

Private companies do not distribute regular dividends, and therefore, future dividend distribution is unpredictable. The free cash flow model would also be unreliable for valuing relatively new private companies due to the high uncertainty surrounding the business itself. However, in the early stages of a private company with a high growth rate, the FCF model may be a better option for common equity valuation. 

Valuation of Cyclical Companies

Cyclical companies are those that experience high volatility of earnings based on business cycles. This can lead to difficulties in forecasting future earnings. Forecasting earnings is a base for the DCF models (be it DDM or FCF model). The relationship between risk and return implies that increased risk shall be accounted for in an increased discount rate, making the model even more complicated. As a result, if an investor chooses the DCF model to value a cyclical company, they will most likely get inaccurate results. The comparable method can better solve the cyclicality problem.

The Bottom Line

A mix of factors impacts the choice of which equity valuation model to choose. No one model is ideal for a certain type of company. Ideally, both models should yield close results, if not the same. The DCF model requires high accuracy in forecasting future dividends or free cash flows, whereas the comparables method requires the availability of a fair, comparable peer group (or industry), since this model is based on the law of one price, which states that similar goods should sell at similar prices (thus, similar revenues earned from the similar sources should be similarly priced).