There are a number of different valuation techniques that can be used to assess the value of a company, and each have their own strengths and weaknesses. We are going to run through a few common valuation techniques and examine their differences:
DCF Techniques: there are a number of discounted cash flow techniques, all sharing the basic premise that the value of a company is the sume of the cash flows a company will produce, discounted at an appropriate cost of capital.
Dividend Discount Model: The dividend discount model uses the dividends paid by the company to assess value. The underlying concept that supports the use of the dividend discount model is that an investor who does not have control of the company will generally receive cash from the company in the form of dividends, which may or may not represent all the cash flow the company generates. Given the investor cannot control the internal cash flows of the company if it does not have control of the company, an investor should only value the cash flows it receives. In this instance, the investor has supplied equity capital into the company, and as such the appropriate discount rate is the cost of equity.
Free Cash Flow to Equity Model: This model discounts all the free cash flow that ends up in the control of the equity holders after paying all expenses and superior capital claims (generally debt, hybrids). This model is appropriate for valuing companies when the capital structure that is in place is expected to remain in place or be changed by existing equity holders over a longer period of time whereby the cost of equity and other capital claims are relatively predictable. One weakness of this model is that it does not look at what the source of the equity cash flows is, and can therefore potentially misvalue cash flows that include debt drawdowns or repayments. The appropriate discount rate again is the cost of equity.
Unlevered Free Cash Flow Model: This model is also often referred to as the Free Cash Flow to the Firm model. This model involves taking the cash flow available to pay all capital providers, assuming the company has an optimal capital structure in place. This model is used in order to value the assets or enterprise of the company instead of a particular tranche of the company's capital structure. It is particularly useful for acquisition valuation, and for distressed situations where the value of the company may be less than the value of debt the company is carrying. The discount rate used in this valuation technique is the weighted average cost of capital (WACC), assuming an optimal capital structure for the company.
Residual Income Model: The residual income model discounts economic profits that the company generates (which is different from cash flows), and again assumes an optimal capital structure. The model uses NOPAT, which is calculated as EBIT x (1 - tax rate) as the 'cash flow' to be discounted, but also deducts a capital charge each year to determine what profit was generated above the cost of capital each year. Again this model uses the WACC as the discount rate.