A good financial analyst should also be aware that besides the most commonly used Discounted Cash Flow (DCF) approach and Market Multiples approach, there are a number of alternative financial valuation techniques that can be used to provide different viewpoints in a financial modeling and valuation exercise.
Alternative valuation techniques, when used in combination with the DCF or Market Multiples approach, allow investors or business owners form a holistic view through multiple perspectives on the value of the business under consideration.
Alternative valuation concepts include Asset Replacement Cost and Control Premium.
Asset Replacement Cost
Assessing the adjusted cost of replacing the useful assets of a business is a useful way of valuing capital intensive businesses such as those in the infrastructure and industrial related sectors.
The term “Control Premium” refers the the extra that typically must be paid to gain operating control of the business. An acquirer wanting control over the operations of a business is likely to want to pay a control premium as it will give the acquirer:
- The ability to set dividends
- Control over investment policy
- Control over compensation
A good financial analyst should know that there is no one ‘best technique’ in financial valuation.
The appropriate valuation technique to use will depend upon a number of characteristics of the firm being valued.
Analysts valuing a firm or its equity have to choose between three different approaches and within each approach, between different models.
While the DCF approach is theoretically superior to the use of market multiples, in practice, it is advisable to use both in a financial modeling exercise. Ideally, first do a DCF and then seek confirmation in the form of multiples.
The issues that a financial analyst can consider whilst making choices on the types of valuation techniques to use in a financial model include the following:
- The level and quality of earnings
- Growth rate in earnings
- Percentage of FCF to equity paid out as dividends (dividend policy)
- Stability of leverage
- Number of quality of comparables available to use market multiples
- Type of business
A good financial analyst will typically consider several different valuation techniques in parallel to arrive at a “fair valuation” for the business under consideration.
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