One of the most common criticisms of DCF models is that any forecast beyond a couple of years is questionable. Investors, therefore, are alleged to be better off using more certain, near-term earnings forecasts. Such reasoning makes no sense, for at least two reasons. First, a key element in understanding a business’s attractiveness involves knowing the set of financial expectations the price represents. The market as a whole has historically traded at a price-to-earnings multiple in the mid-to-high teens. Simple math shows today’s stock prices reflect expectations for value-creating earnings and cash flows many years in the future. The mismatch between a short forecast horizon and asset prices that reflect long-term cash flows leads to the second problem: investors have to compensate for the undersized horizon by adding value elsewhere in the model. The prime candidate for the value dump is the continuing, or terminal, value. The result is often a completely non-economic continuing value. This value misallocation leaves both parts of the model—the forecast period and continuing value estimate—next to useless. Some investors swear off the DCF model because of its myriad assumptions. Yet they readily embrace an approach that packs all of those same assumptions, without any transparency, into a single number: the multiple. Many companies require over ten years of value-creating cash flows to justify their stock prices. Ideally, the explicit forecast period should capture at least one-third of corporate value with clear assumptions about projected financial performance. While the range of possible outcomes certainly widens with time, we have better analytical tools to deal with an ambiguous future than to place an uncertain multiple on a more certain near-term earnings per share figure. We address the uncertainty issue below. In reference to the hostile bid of €694 million, what the free cash flow model tells us is that the company is valued around €788 million. The hostile bid from Ryan air is massively undervalued. We must bear in mind that this is only one model and for a complete analysis, we must look at different models and compare.
Analysts like to use the free cash flow valuation model whenever one or more of the following conditions are present: * The firm is not dividend paying,
* The firm is dividend paying but dividends differ significantly from the firm’s capacity to pay dividends, * Free cash flows align with profitability within a reasonable forecast period with which the analyst is comfortable, or * The investor takes a control perspective.
Free cash flow to the firm (FCFF) is the cash flow available to the firm’s suppliers of capital after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made. The FCFF valuation approach estimates the value of the firm as the present value of future FCFF discounted at the weighted average cost of capital (WACC)
What other models out there?
The Price / Earning Ratio (P/E)
Current Share Price
Earnings Per Share (EPS)
The advantages of the P/E Ratio are that it is simple to calculate. It is always widely used throughout the financial world by investors and firms. It could be considered a decent proxy for the present value of future cash flows. It is also a better indicator of share’s value than market price alone. The disadvantages are that the ratio includes no thought of the risk factor. Differing versions of the calculation (trailing P/E/trailing P/E from continued operations or Forward P/E) can make analysis difficult. The ratio doesn’t take into account the time value of money. It also uses accounting information, which can change or be misinterpreted and is only really useful when compared with the industry and competitors.
Book Value Calculation
Historical cost of assets (adjusted for depreciation) – liabilities...
References: Arnold, G. (2008) Corporate Financial Management, Financial Times Prentice Hall
McGuigan, J. , Kretlow, W. , & Moyer, C. (2009) Contemporary Corporate Finance, South-Western CENGAGE Learning
Lumby, S. , Jones, C. (2011) Corporate Finance Theory & Practice, South-Western CENGAGE Learning
Megginson, W. , Smart, S. , & Lucey, B. (2008) Introduction to Corporate Finance, South-Western CENGAGE Learning
Brealey, R. , Myers, S. , & Marcus, A. (2001) Fundamentals of Corporate Finance, McGraw-Hill Irwin
Fraser-Sampson, G. (2011) No Fear Finance, Kogan Page
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