Valuing Assets in Financial

Markets
Valuation
The process of determining the economic
value of a business or company
The process of determining the current worth
of an asset or company
Valuation can be used to determine the fair
value of a business for a variety of reasons
There are many techniques that can be used
to determine value, some are subjective and
others are objective
Judging the contributions of a company's
management would be more of a subjective
valuation technique, while calculating intrinsic
value based on future earnings would be an
objective technique
Types of Valuation
Techniques
Relative Valuation
Multiples Valuation
P/E ratio
Price/Book Value
Enterprise Value/EBITDA
Price/Cash Flow
Arbitrage Valuation
Fundamental Valuation
DCF
Multiples
Based on the idea that similar assets sell
at similar prices
Multiples compare a value ratio for one
asset to another at a particular point in
time
Identify the set of comparable assets
Market value of these assets are used as
the basis for valuation
Ratios are calculated using the market
value to some characteristic of
underlying asset
5
P/E multiple
Valuation for an IPO,
Value of firm = Average Multiple of Recent
Transaction EPS of firm
Valuation to estimate firm value,
Value of firm = Average P/E multiple in industry
EPS of firm
This method can be used when
firms in the industry are profitable (have positive
earnings)
firms in the industry have similar growth (more
likely for mature industries)
firms in the industry have similar capital structure


6
P/E multiple
Example: Valuing a firm (EPS=$2.0) using P/E ratio

Suppose there are four stocks which are
similar to the stock we want to evaluate

Average P/E = (14+18+24+21)/4
= 19.25
Price of the stock of our firm = 19.25*2
= $38.50




Arbitrage Valuation
Assumption: Active financial markets
exist where individuals are looking for
opportunities to profit from the relative
pricing of the assets
Law of one price
Buy lower priced asset and Sell higher
priced asset (same risk, amount &
timing of cash flows)
Challenges
Finding traded assets similar to the
asset we wish to value, they can differ
in terms of risk, growth prospects, tax
status
Estimating the attributes of identified
similar asset
Can not compare value across
different asset classes (stocks vs.
bond vs. real estate, etc).

Discounted Cash Flow
Inputs: Free cash flow forecasts,
Discount rates and perpetuity growth
rates
DCF is used to estimate the
attractiveness of an investment
opportunity
DCF analysis uses future free cash flow
projections and discounts them to
arrive at a present value, which is then
used to evaluate the potential for
investment

Discounted Cash Flow
Discount Rates
Risk Adjusted Rate:
R=Risk Free Rate + Risk Premium
Incorporates the risk associated with the
cash flows and the time value of money
Risk Free Rate
Incorporates only the time value of money.
Risk is taken care of by adjusting the
estimated cash flows (Certainty Equivalent)
Challenges
DCF model is only as good as its input
assumptions. A small change in the
inputs might result in a large change in
the value of a company
Success of DCF method is directly
related to whether one can predict the
future cash flows accurately or not
DCF model is not suited to short-term
investing
Ignores the current level of the stock
market