Advantages | Disadvantages |
Easy to understand and apply Fewer assumptions used than with DCF Better captures current mood of market | Choice of multiples sometimes subjective Difficult to find comparables with identical, or at least similar, revenue drivers Assumption that market accurately values the peer group |
Which Model to Use
The choice between these two alternative valuation models will depend on specific factors, such as availability and accuracy of the inputs (revenue drivers,businesscycles, etc.).
Dividend-Paying, Mature and Stable Companies
The DDM model is best applied for stable and mature public companies that pay dividends. For example, BP plc. (BP), Microsoft Corporation (MSFT)and Wal-Mart Stores, Inc. (WMT) pay regular dividends and can be characterized as stable and mature businesses. Therefore, the DDM can be applied to value these companies.
The FCF model can be used to calculate the valuation of companies that do not pay dividends or pay dividends in an irregular fashion. This model is also applied for those companies with a dividend growth rate that does not properly capture the earnings growth rates.
Companies with Diverse Revenue Drivers
When a company valued has a diversified revenue source, the free cash flow method can be a better approach than the comparable method, simply because finding a true comparison can be problematic. Today there are a number of large-cap companies with diversified revenue drivers. This feature makes it challenging to find a relevant peer group, company, or even industry multiples.
For example, both Canon Inc. (CAJ) and Hewlett-Packard Company (HPQ) are large manufacturers of printing machines for business and personal use. However, HP’s revenue also is derived from the computer business. HP and Apple are both competitors in the computer business, but Apple derives its revenue mostly from sales of smartphones and its built-in app store.
Apparently, neither Canon and HP, nor HP and Apple, can be in a peer group in order to use a peer group multiple.
Valuation of Private Companies
There is no straightforward choice of valuation model for private companies. It will depend on the maturation of the private company and the availability of model inputs. For a stable and mature company, the comparables method can be the best option.
In general, it is very complicated to get the inputs required for the DCF model from private companies. The beta, which is one of the key inputs for a returns estimation of a private company, is best estimated using comparable firms’ betas. This makes it challenging to apply the DCF model.
Private companies do not distribute regular dividends, and therefore, future dividend distribution is unpredictable. The free cash flow model would also be unreliable for valuing relatively new private companies due to the high uncertainty surrounding the business itself. However, in the early stages of a private company with a high growth rate, the FCF model may be a better option for common equity valuation.
Valuation of Cyclical Companies
Cyclical companies are those that experience high volatility of earnings based on business cycles. This can lead to difficulties in forecasting future earnings. Forecasting earnings is a base for theDCF models (be it DDM or FCF model). The relationship between risk and return implies that increased risk shall be accounted for in an increased discount rate, making the model even more complicated. As a result, if an investor chooses the DCF model to value a cyclical company, they will most likely get inaccurate results.The comparable method can better solve the cyclicality problem.
The Bottom Line
A mix of factors impacts the choice of which equity valuation model to choose. No one model is ideal for a certain type of company.Ideally, both models should yield close results, if not the same. The DCF model requires high accuracy in forecasting future dividends or free cash flows, whereas the comparables method requires the availability of a fair, comparable peer group (or industry), since this modelis based on the law of one price, which states that similar goods should sell at similar prices (thus, similar revenues earned from the similar sources should be similarly priced).
