Corporate and Project Finance Modeling

Chapter 27Four General Terminal Value Methods

The discounted cash flow (DCF) model is the culmination of a series of finance theories encompassing Modigliani and Miller, the capital asset pricing model (CAPM), and the philosophy that companies with an indefinite life eventually reach some kind of stable equilibrium. In theory, a DCF analysis should be made that reflects the fundamental factors that drive the value of a company, including return on capital, cost of capital, and growth rates. The DCF method is the central valuation approach taught by academics, and in its pure form it is not dependent on the opinions of other investment analysts. The primary alternative valuation approach to the DCF model applies multiples such as the price/earnings (P/E) ratio and enterprise value/earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) to current or projected income. Application of multiples is sometimes called relative valuation because, in contrast to the DCF model, these valuations are at least in part dependent on the judgments of others. P/E and EV/EBITDA multiples taken from a comparable sample indirectly depend on the implied returns required in the market as well as expectations of future income growth. When using multiples and relative valuation, you are constrained by the implicit assumptions that players in the market have made about future rates of return, risks, and growth.

In spite of the theoretical advantages of the DCF model in its pure form ...