Discounted cash flow model of valuation.
The discounted cash flow (DCF) model is a common way to figure out how much an investment is really worth. In the DCF model, you project future cash flows and then use a discount rate to bring them back to their present value. There are many good things about the DCF model, but there are also some bad things to think about.
Benefits: It analyzes: The DCF model uses fundamental analysis to anticipate future cash flows based on financial statements and industry trends. Because it considers both present finances and future profits potential, this strategy is better for valuing a company (Fernandez, 2019).
Change it: The DCF model can be adjusted to account for interest rate changes, inflation, and company-specific risks.
It works for all investments: The DCF model works for equities, bonds, and real estate. It’s a versatile approach to value things.
Clear estimate: All stakeholders can understand the DCF model’s valuation. Businesses seeking funding or acquisitions can benefit from this.
Disadvantages:
Use of assumptions: The DCF model is affected by calculation assumptions like discount rate and growth rate. Small assumptions might modify the predicted value significantly, making the estimate less credible.
It needs precise predictions: Financial forecasts greatly affect DCF model accuracy. If these predictions are inaccurate, too will the valuation.
DCF models involve time and financial analysis. Companies without funds or time may not be able to do this.
Looking back: The DCF model predicts future cash flows using historical financial statements. This means that it might not account for changes in the business model of the company or the strategies used by its rivals, which could have an impact on how much money the company makes in the future (Pinto, 2020).
The DCF model has many advantages, including a fundamental analysis foundation, flexibility, and applicability to a wide range of investment kinds. However, it also has several drawbacks, including the necessity for precise estimates, a lengthy process, and sensitivity to presumptions. The investment and analysis resources determine whether the DCF model is useful.
Discounted residual income.
A company’s equity’s intrinsic value is calculated by projecting future residual income and discounting it to its present value using a needed rate of return. Residual income is net income minus a company’s equity charge (cost of equity multiplied by beginning book value).
Advantages:
Future oriented: DRI appreciates future residual income, not past financial results. It aids company evaluation.
Market expectations: DRI values market expectations using equity cost. (Fernandez, 2019).
shareholder value: The DRI model compares a company’s actual residual income to its cost-of-equity-based forecasted residual income.
Performance evaluation: The DRI model may evaluate a company’s actual and expected residual income. Investors and analysts can uncover shareholder-value-creating companies.
Disadvantages:
Limited by accounting measure: Financial estimates underpin DRI. Forecasts affect valuation.
DRI models require financial analysis. DRI may not work for many companies or assets, especially those with limited residual income.
The DRI model, like the DCF model, depends on assumptions like the needed rate of return and residual income growth rate. Assumptions can dramatically change the anticipated value, making it less accurate.
The DRI model is a forward-looking valuation method that incorporates market expectations, value generation, and success. Its drawbacks include reliance on accurate forecasts, time-consuming, limited applicability, and assumptions. Like any valuation tool, the DRI model’s efficacy depends on investment setting and analysis resources (Budagaga, et al, 2020).
Net asset valuation Model.
Estimating a company’s assets with the net asset value (NAV) approach is popular. NAV calculates the company’s net asset value by subtracting liabilities from assets. NAV benefits and detracts:
Advantages:
Easy to understand: NAV requires no financial analysis or forecasting.
Asset-based firms benefit: Real estate investment trusts employ NAV because asset value drives value.
Objecive: Stakeholders can easily value NAV. This aids fundraising and mergers.
It works: Because it employs actual assets and liabilities, the NAV model is accurate.
Disadvantages:
It overlooks future earnings: NAV ignores growth and earnings potential. It may undervalue growth companies (Morozova, 2020).
It deceives: Undervalued assets or liabilities may mislead the NAV model. This can over- or undervalue the company.
The NAV strategy ignores intangibles like intellectual property, brand value, and customer ties, which can add value to many firms.
Not all firms need it: Intangible assets and future earnings may not work with the NAV model.
For asset-based companies, NAV is straightforward, dependable, transparent, and effective. The NAV model’s shortcomings include ignoring future earnings potential and intangible assets, misleading valuation, and limited applicability to certain companies or investments. Its effectiveness depends on the investment’s environment and resources.
Multiple model of valuation.
Multiple valuation models are used to value a firm or asset. Analysts and investors use this method to more accurately appraise a company by examining several criteria.
Multiple model valuation provides a more complete study of the firm or asset being appraised. Different valuation methods help the analyst assess the company’s financial health, growth prospects, and market position. Multiple models lessen the impact of any one method’s limits, biases, or inaccuracies, resulting in a more accurate valuation.
Multiple model analysis lets analysts explore different situations and assumptions. An analyst can test assumptions like growth rates and discount rates and assess their influence on valuation by employing multiple valuation models. This improves analysis, decreasing valuation errors.
It’s complicated and time-consuming to implement. Valuing a company or asset using numerous models demands significant skill and resources, which can be a difficulty for smaller firms or individual investors.
Multiple model outputs can dispute, another downside. Different valuation models use different assumptions and approaches, so their conclusions can vary, making it hard to determine a valuation.
The multiple model of valuation gives a more complete study of a firm or asset’s value, which can improve accuracy. It demands skill and resources and can produce inconsistent outcomes. Thus, while valuing a firm or asset, the multiple model approach should be carefully considered and used wisely.
Critically discuss the advantages and disadvantages of the multiple model of valuation
The multiple model of valuation compares a company’s financial performance to similar companies in the same industry. The multiple model calculates a valuation metric, such as P/E, P/B, or EV/EBITDA, and compares it to industry peers. Multiple models have pros and cons.
Advantages:
It’s market-based: The multiple model uses market data to evaluate publicly listed companies with many comparable companies in the same industry.
Widely used: The multiple model simplifies industry comparisons for investors and analysts.
Incorporates future expectations: The multiple model compares the company’s financial performance to others in its industry. This helps detect overvalued or undervalued enterprises.
Disadvantages:
Multiple models vary by industry and company. In a specialist industry, it may not correctly reflect the company’s value.
It ignores individuality: The multiple approach ignores corporate factors including management, competitive advantage, and growth potential. If market data doesn’t represent these features, it may not adequately reflect the company’s genuine value.
Market fluctuations: Market fluctuations can overvalue or undervalue the stock price using the multiple model.
It may miss industry changes: The multiple model may not account for industry or economic factors that may affect the company’s financial success.
The multiple model is simple, relies on market data, and may be used to compare organizations across industries. Its drawbacks include a significant dependence on the industry, the possibility of mistakes owing to the company’s unique characteristics, market swings, and the possibility of not accounting for industry or economic trends. The multiple model’s usefulness depends on the investment’s setting and resources.
Part C.
M&As combine two or more companies into one. M&A activity is financially justified by:
Synergy is M&A’s main economic basis. Synergy occurs when two or more companies work together to create a greater whole. Mergers can reduce costs due to economies of scale, market strength, or operational efficiency (Chen, Liang, and Wu, 2023).
Diversification: M&A can help corporations enter new markets, expand their product lines, or reduce their dependence on one product or market.
Growth: M&A can help organizations gain new consumers, market share, and innovations or IP.
M&A can boost revenue, profitability, and cash flow.
M&A activity benefits stakeholders unequally. Depending on the agreement, stakeholders may gain or lose. M&A activity benefits stakeholders like:
Shareholders: The deal may boost the acquiring company’s share price.
Management: Bonuses and stock options may benefit management.
Employees: Job stability, professional advancement, and perks may improve.
Customers: Product offerings, quality, and service may improve.
M&A activity may hurt some interests. These are:
Redundancies and restructuring may affect acquired firm employees.
Suppliers: The merged entity’s market power may weaken suppliers’ bargaining power.
Customers: If the merged business raises prices, lowers quality, or cuts products, customers may lose.
In conclusion, M&A activity can help organizations and stakeholders financially. However, not all stakeholders profit. Before making a deal, corporations must carefully assess how M&A activity will affect all stakeholders.
