Equity Valuation: Models from Leading Investment Banks

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Introduction

In recent years, managers, under pressure from stockholders and activist investors, have turned their attention increasingly to ways in which they can increase firm value. A number of competing measures, each with claims to being the “best” approach to value creation, have been developed and marketed by investment banking firms and consulting firms. In this part, we look at four basic approaches to valuation and how value enhancement is framed in each one. First, we look at discounted cash flow models and their variants – certainty equivalents, excess return models and adjusted present value models – and note that to increase value in these models, we have to generate a tangible impact on either cash flows or discount rates. Second, we examine accounting valuation models – book value and liquidation value – and why value enhancement in these models is often cosmetic, tailored to accounting conventions and considerations rather than what is best for the firm in the long term. Third, we evaluate relative valuation models, where assets are priced based upon how the market is pricing similar assets, and look at how value enhancement can be adapted to meet market considerations. Finally, we consider real options models, where value can be derived from increasing flexibility and potential opportunities in the future, and the interaction between corporate strategy and finance in value enhancement.

Financial theorists have long argued that the objective in decision making ...