18.3. CHOOSING THE RIGHT DISCOUNTED CASH FLOW MODEL

The model used in valuation should be tailored to match the characteristics of the asset being valued. The unfortunate truth is that the reverse is often true. Time and resources are wasted trying to make assets fit a prespecified valuation model, either because it is considered to be the best model or because not enough thought goes into the process of model choice. There is no one "best" model. The appropriate model to use in a particular setting will depend on a number of the characteristics of the asset or firm being valued.

18.3.1. Choosing a Cash Flow to Discount

With consistent assumptions about growth and leverage, we should get the same value for our equity using the firm approach (where we value the firm and subtract outstanding debt) and the equity approach (where we value equity directly). If this is the case, you might wonder why anyone would pick one approach over the other. The answer is purely pragmatic. For firms that have stable leverage (i.e., they have debt ratios that are not expected to change during the period of the valuation), there is little to choose between the models in terms of the inputs needed for valuation. We use a debt ratio to estimate free cash flows to equity in the equity valuation model and to estimate the cost of capital in the firm valuation model. Under these circumstances, we should stay with the model that we are more intuitively comfortable with.

For firms that have unstable leverage ...

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