Saturday, September 01, 2007

DCF/Relative Valuation


Consistencies in DCF
• If we use real cash flows for forecasting (ie don’t build in inflation) we should use a real discount rate and not a nominal rate.
• If there is some source of other income like cash or marketable securities
a) Either build the annual income every year in your cash flow forecasts
b) Or deduct the total source of income after calculating enterprise value …logic being to acquire a company you need to pay EV but you also get the company’s cash which can be used to reduce your acquisition costs. Second method is preferable as it doesn’t involve forecasting such cash flows every year

Assumptions of Valuation methods
o DCF assumes mkt price may deviate from intrinsic value in short term but will get corrected over the long term
o Relative valuation assumes while individual companies might be mispriced the sector or the mkt as a whole is priced properly

Can a Firm be Undervalued and Over valued at the same time
If DCF shows a firm is overvalued however relative valuation suggests it is undervalued – the whole sector in fact might be overvalued and vice-versa. Eg. In March 2000, Amazon’s DCF value was $30, it traded at 70$ (overvalued), however still appeared cheaper on a relative basis compared to other internet companies.

Source-
• Damodaran on Valuation – Second Edition
• Job interviews :)

1 comment:

I me myself said...
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