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FNCE221 Invididual Write Up #1 Valuation

1. DCF valuation approaches are concerned with determining the fair value of the equity
capital (or intrinsic value). The DCF valuation approach can be divided into two methods, the
direct method, FCFE, or the indirect method, FCFF. The direct method, FCFE, values the
companys equity capital directly, whereas FCFF method measures the enterprise value of the
firm, subtract away net debt to arrive at equity value. In essence, FCFF is the cash available to
bond holders and stockholders after all expense and investments have taken place while FCFE
is the cash available to stock holders after all expense, investments and interest payments to
debt-holders on an after-tax basis.

As such, we can see that the key difference between the two lies with the consideration of
interest payments in FCFE and not FCFF and also that FCFE considers obligations of
stockholders only whereas FCFF considers both debt and equity holders of the firm.

In practice, capital structure of the firm would be one of the key considerations in
determining which method to employ. In general, for firms with a stable leverage, FCFE would
be used, as it is relatively simpler than FCFF to calculate. However, for firms with changing
capital structure or a negative FCFE, FCFF would be more appropriate.

2. When computing beta, the choice of the benchmark should be similar to the assets that
are chosen. By definition, market beta is 1.0, and beta measures the risk that a particular
investment adds to the portfolio relative to this market. In general, one should consider the
market capitalization of the firm. A large cap stock should be compared with a large cap index
such as the S&P500. Another consideration is the origin of the marginal investor. For example
the Straits Times Index should be used if the marginal investor is expected to be from
Singapore. If the marginal investor is a global investor, a global index should be used instead.

3. Different databases use varying methods for calculating beta. For example, Bloomberg
uses a two-year time period in its calculation of beta but it may not hold true for an investors
time horizon. When such assumptions do not hold, equity beta can be estimated by regressing
stock returns against the market return on the chosen index. Other wise, find the unlevered
betas of other firms in similar businesses and using a weighted average of the unlevered betas
by segment and lever up using the firms D/E ratio.

4. Secondary methods of valuation assume that the market prices the values of assets
correctly. While individual assets might be incorrectly priced, on average, this should be
corrected over time. The most difficult issue is finding comparable assets that are priced by
the market, as it is important to find firms with as close a business model as the firm under
consideration. In order to select the universe of comparables, it is necessary to have a sound
understanding of the target as well as the targets industry.

While this process could be fairly simple in certain industries, it may not be true for others. A
broad based should be selected first before narrowing the companies based on the targets

5. The premise of the comparables approach to valuation is that the firms equity value
should bear some resemblance to other equities in a similar class. It reflects current valuation
based on prevailing conditions and sentiments. In considering similar companies, the size,
industry risk, business cycle and growth needs to be taken into account. Also, the proximity of
business model should be considered as the closer the firms business model, the more
reliable the valuation will be.

Median values should also be used instead of averages as presence of outliers will skew these
averages. As ratios are used in the valuation, consistency in the definition of the numerator
and the denominator must be ensured for reliability of valuation.