Damodaran on Valuation

1.3. APPROACHES TO VALUATION

Analysts use a wide spectrum of models, ranging from the simple to the sophisticated. These models often make very different assumptions about the fundamentals that determine value, but they do share some common characteristics and can be classified in broader terms. There are several advantages to such a classification: It makes it is easier to understand where individual models fit into the big picture, why they provide different results, and when they have fundamental errors in logic.

In general terms, there are three approaches to valuation. The first, discounted cash flow valuation, relates the value of an asset to the present value of expected future cash flows on that asset. The second, relative valuation, estimates the value of an asset by looking at the pricing of comparable assets relative to a common variable like earnings, cash flows, book value, or sales. The third, contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics. While they can yield different estimates of value, one of the objectives of this book is to explain the reasons for such differences, and to help in picking the right model to use for a specific task.

1.3.1. Discounted Cash Flow Valuation

In discounted cash flow (DCF) valuation, the value of an asset is the present value of the expected cash flows on the asset, discounted back at a rate that reflects the riskiness of these cash flows. This approach gets ...