This chapter introduces two of the most popular equity valuation approaches: discounted cash flow, and comparable or relative valuations. The Appendix, which contains the results of a survey of UK corporate financiers, shows that these are the most frequently relied upon methods of valuation. Other specialised valuation methods are available to corporate financiers (e.g., asset valuations, option-based models), but we leave these to more specialised texts.
We begin by examining the process of bond valuation. Bonds and other fixed interest securities are relatively easy to value, because they promise a fixed stream of interest payments on known dates in the future. Equities, on the other hand, have a much greater degree of uncertainty regarding future dividends and capital appreciation. However, the principles of bond valuation underlie one of the most important business valuation methods.
The core business valuation techniques in use today are derived from the pricing of bonds with fixed interest coupons. An understanding of bond pricing will provide the reader with a grounding in the fundamentals of Discounted Cash Flow (DCF) valuation. To understand the price of a bond, or any promise to pay a sum of money in the future, one starts with the concept of present value.
The simplest way to start is to look at a security that makes only one payment in the future: a zero-coupon bond, introduced in Chapter 2, fits the bill. As you will ...