Choosing a Valuation Model

Now, since we are aware that there are actually multiple models that can be used to value any given company or asset, the next question that arises is which one should we use? How do we know whether a given valuation model is more appropriate for a given company than the others? The answer is that we don’t know for sure. Because valuation is an art all we have are broad guidelines which we can follow while selecting a given valuation model.

Let’s look at some of those guidelines in this article:

Characteristics of the Company:

The first and most important factor is the characteristics of the company that is being valued. Consider the fact that we can value a company like Ford Automobiles based on the amount of assets that they control. However, we cannot use the same technique to value a company like Google. Most assets controlled by Google are intellectual and intangible. If they are not complete they may have no use for the acquirer. Hence, the first factor that needs to be determined is whether the company can be subject to valuation based on its assets. If the company has assets that only they can acquire benefit from or if the assets are largely intangible, the asset valuation model needs to be ruled out.

Next, we also need to consider whether or not a company pays dividends. Utility companies for instance have always paid dividends and are likely to do so in the foreseeable future. On the other hand, companies like Microsoft have not paid dividends for a large part of their existence. Hence, while utility companies can be subjected to discounted dividends valuation, companies like Microsoft cannot be valued in the same manner.

Lastly, the purpose of the analysis must be clear to the person conducting the valuation exercise. The valuation for a short term investment will be different from a long term one. Hence, companies that have competitive advantage can be given a higher premium in the short run in the absence of any threat from the competition.

Characteristics of the Investor:

It may not seem that obvious, but the characteristics of the investor also play a big role in which model needs to be selected for valuation.

For instance, consider the case of a retail investor. A retail investor does have ownership of the asset. However, they do not have control over the assets. Hence, they are at the mercy of the dividend policy of the company and cannot predict their cash flows in any other manner. In this case, a discounted dividend approach may be more suitable as compared to other approaches.

Now, consider the case of an institutional investor. Institutional investors have deep pockets and are capable of buying a stake which is large enough to get the management to change the dividend payout policy. In this case, the discounted dividend model may not be very applicable. Instead what matters is the amount of free cash flow that can be generated by the company. Hence institutional investors tend to use discounted free cash flow models more often.

Lastly, if a competing firm makes an acquisition, then they can not only influence the dividend payout policy but the day to day functioning of the firm. Hence valuation here will be more accurate if the discounted residual income model is used.

Purpose of Investment:

Lastly, the purpose of investment also plays a major role in the valuation model being chosen.

For instance, consider the case when a conglomerate company makes an acquisition in an unrelated business. Here, the value derived by the investors will be directly related to the value of the assets themselves. The concept of synergy and the increase in value may not be applicable there.

On the other hand, if a competing firm makes an acquisition, they can benefit from the economies of scale and other synergies that come with the acquisition of a business. Hence in this case the concept of synergy may also be applicable.

Also, sometimes investors acquire private companies, only to make an exit by taking them public later on. In such case the valuation will totally depend on the retail investor’s perception of value of that company. Hence, a different valuation model may have to be used.

Multiple Models:

An important point to note is that investors often use multiple models to derive the valuation of a company, instead of using a single model. The benefit of using multiple models is that the analyst can verify whether they are getting the same or similar measures of value from all models.

If the estimates are not similar, they will still gain a better understanding as to what the root cause of the higher valuation is and whether it is worth the additional premium.

Hence, using multiple valuation models is always preferred to coming up with a valuation based on a single model.