Question

Discuss the insights for enterprise valuation provided by each of valuation models

(i) Free cash flow valuation model

(ii) Residual operating income valuation model

(iii) Abnormal operating income growth model

And explain why they may not always generate the same valuation when used to estimate a firm’s value in practice.

Answer 1

(i) Free cash flow valuation model – As per this model the enterprise value is present value of its free cash flows. The model involves projecting cash flows into future and then discounting them at the cost of capital. The free cash flow to the firm (FCFF) is discounted to arrive at the total enterprise value.

(ii) Residual operating income valuation model – Residual income is the income generated by a firm after it has accounted for its true cost of capital. Residual income = net income – (equity capital*cost of equity). Under this valuation technique the enterprise value is determined by adding book value of a firm and the present value of its expected future residual income. To determine the present value of its expected future residual income a firm will use its cost of equity (and not cost of capital as in case of free cash flow valuation model).

(iii) Abnormal operating income growth model – Under this model operating income is forecasted and then the abnormal growth rate in operating income is also forecasted. The value is derived using the formula: Value = 1/required rate of return*[Operating income+(Abnormal Operating Income Growth/(1+required rate of return – g))] – NFO

The above methods may not always generate the same valuation when used to estimate a firm’s value in practice due to the fact that there might be a level of subjectivity that is involved in some cases. For instance while forecasting free cash flows one has to forecast different line items like sales, costs, assets, capital expenditures, and growth rate, etc. The forecast may differ from one analyst to another. Secondly free cash flow valuation model uses cost of capital for discounting purpose while residual operating income valuation model uses cost of equity for discounting. This may lead to different results in practice.