Damodaran on Valuation

18.1. CHOICES IN VALUATION MODELS

In the broadest possible terms, firms or assets can be valued in one of four ways— asset-based valuation approaches where we estimate what the assets owned by a firm are worth currently, discounted cash flow valuation approaches that discount cash flows to arrive at a value of equity for the firm, relative valuation approaches that base value on multiples, and option pricing approaches that use contingent claim valuation. Within each of these approaches, there are further choices that help determine the final value. (See Figure 18.1.)

There are at least two ways in which we can value a firm using asset-based valuation techniques. One is liquidation value, where we consider what the market will be willing to pay for the assets if they were liquidated today. The other is replacement cost, where we evaluate how much it would cost us to replicate or replace the assets that a firm has in place today.

In the context of discounted cash flow valuation, cash flows to equity can be discounted at the cost of equity to arrive at a value of equity, or cash flows to the firm can be discounted at the cost of capital to arrive at the value for the firm. The cash flows to equity themselves can be defined in the strictest sense as dividends or in a more expansive sense as free cash flows to equity. These models can be further categorized on the basis of assumptions about growth into stable-growth, two-stage, and three-stage models. Finally, the measurement of earnings ...