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APPROACHES TO VALUATION
Analystsusea widespectrum ofmodels,rangingfrom the
simpleto thesophisticated.Thesemodelsoftenmakevery
differentassumptionsaboutthefundamentalsthatdetermine
value,buttheydosharesomecommoncharacteristicsandcan
beclassifiedinbroaderterms.Thereareseveraladvantagesto
suchaclassification:Itmakesitiseasiertounderstandwhere
individualmodelsfitintothebigpicture,whytheyprovide
differentresults, andwhentheyhavefundamentalerrorsin
logic.
Ingeneralterms,therearethreeapproachestovaluation.The
first,discountedcashflowvaluation,relatesthevalueofan
assetto thepresentvalueofexpectedfuturecash flowson
thatasset.Thesecond,relativevaluation,estimatesthevalue
ofan asset by lookingatthepricing ofcomparable assets
relativetoacommonvariablelikeearnings,cashflows,book
value, orsales. Thethird,contingentclaim valuation,uses
option pricing modelsto measure thevalue of assets that
share optioncharacteristics. While theycan yielddifferent
estimatesofvalue,one oftheobjectivesofthis bookisto
explain the reasons for such differences, and to help in
picking the right model to use for a specific task.
Discounted Cash Flow Valuation
In discounted cash flow (DCF) valuation, thevalue of an
assetisthepresentvalueoftheexpectedcashflowsonthe
asset,discountedbackataratethatreflectstheriskinessof
these cash flows. This approach gets the most play in