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Equity Valuation: Models from Leading Investment Banks by Armin Varmaz, Thorsten Poddig, Jan Viebig

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Summary

The aim of this Part is to give a brief overview of some general valuation concepts and principles from a theoretical point of view. We showed that three alternatives exist to incorporate uncertainty into the DCF valuation framework. First, risk-adjusted cost of equity can be used to discount expected cash flows. Practitioners usually apply the CAPM to estimate cost of equity. Above we argued that the CAPM is based on a number of restrictive assumptions. The wide acceptance of the CAPM in practice is probably based on the simplicity of the underlying economic model.

Secondly, risk can be incorporated into the valuation framework by applying utility-based valuation. Utility-based valuation requires only a few assumptions of the decision behavior of investors and no assumptions about capital markets. The utility-based valuation framework requires that investor-specific utility functions can be estimated. Most practitioners reject this approach as, in practice, it is almost impossible to adequately determine and aggregate individual utility functions and estimate risk aversion parameters. Thirdly, risk neutral probabilities can be applied to incorporate uncertainty into the valuation framework. The estimation of RNP requires the use of sophisticated econometric models.

Despite these difficulties, a lot of academic research is done on RNP valuation. In addition, financial economists have formulated more sophisticated factor models which better explain average historical ...

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