Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition

CHAPTER 2

Approaches to Valuation

Analysts use a wide range of models in practice, ranging from the simple to the sophisticated. These models often make very different assumptions, 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 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 (DCF) valuation, relates the value of an asset to the present value (PV) 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 such as 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. Some of these assets are traded financial assets like warrants, and some of these options are not traded and are based on real assets, (projects, patents, and oil reserves are examples). The latter are often called real options. There can be significant differences in outcomes, depending on which approach is used. One of the objectives in this book is to explain the reasons for such differences in value across different models, and to help in choosing the right model to use ...