Accounting Quality

Pros and Cons of 5 Valuation Models

Discounted Dividend Model

Value of a firms equity as the PV of forecasted future dividends

Values equity hence use cost of equity

Pros

Easy to understand, and built off the basis of theory that states that when an investor buys shares in a
business they are paying a price today that allows them to enjoy benefits of perpetual dividend
distributions no subjectivity
Values a companys stock without accounting for market conditions, easier to make comparisons
regarding companies across different markets and industries
Consistency dividends are generally consistent for a long period of time unlike FCF and earnings,
which fluctuate more throughout time

Cons

Valuation model is particularly sensitive to growth

Assumes that dividends are linked to earnings higher earnings = higher dividends not true as
companies attempt to maintain a stable dividend payout rate
Variety of uncontrollable assumptions such as growth rate, interest rates and tax rates which are
stipulated by external bodies, hence reducing validity of the model
Dividend policy irrelevance M&M states that the MV of a firm is determined by its earning power
and its underlying assets and is independent of the way it chooses to distribute dividends and finance
its activities
Arbitrary and not linked to value add
Focuses on wealth distribution not creation also focuses on assumption that companys dividend
growth is stable and known, cannot be used for companies with no dividend distribution

Multiples
Pros

Simple to use, and easy to understand

Fewer assumptions than DCF
Able to capture to capture a more holistic view of market conditions
Easy to apply and require very basic maths skill commonly used denominators do not have to be
forecasted because multiples are typically applied to projections of current year or next years
revenue

Cons

Assumes that the market is correctly valuing the peer group leading to valuation errors if the entire
group is under or overvalued
The valuing of stocks using multiples is high subjective as an individual can choose whichever
multiple that he/she chooses to

Residual Operating Income Model

Pros

Values the firm and returns through the cost of capital

Focuses on value drivers such as profitability, and growth on investment rather than dividend
Incorporates the BS and P&L
Uses accrual accounting, matching value add to value lost (treats investments as an asset)
Aligns with what people forecast
Can be used with a variety of accounting principles

Cons

Accounting complexity requires understanding of how accounting works

Suspect accounting accounting numbers can be suspect, easy to manipulate
Forecast Horizon Forecast horizon depends on the quality of the accounting

Residual Income Model

Value of the firms equity expressed as the sum of its BV and discounted forecasts of abnormal
earnings or residual income
Values equity
Equity value = book value of equity + PV of future abnormal earnings

Pros & Cons

Same as above

DCF

Forecasts of cash flow, which are subsequently discounted at the firms estimated cost of capital
(WACC) to arrive at an estimated PV
Values assets

Pros

Can be applied to valuing businesses as a whole and also for valuing individual business components
DCF model is forward looking and depends on future expectations rather than historical results
DCF model relies on fundamental expectations of a business, hence it is less influenced by volatile
external factors
DCF model is focused on cash flow generation and less affected by accounting practices and
assumptions

Cons

Heavily dependent on inputs used for valuation purposes, so if input assumptions are incorrect then
the DCF will fluctuate and it will lead to inaccuracies
DCF works best when there is a great degree of confidence regarding future cash flows, however
there may not be visibility, hence it can create difficulties in estimation
Forecast horizons: DCF model is not suitable to short-term investing, as it does not recognise cash
inflows from investments in the short term
Not aligned with what people forecast analysts generally forecast earnings not free cash flows,
hence adjusting earnings forecasts to free cash flows requires additional forecasting of accruals
Does not measure value add: FCF doesnt measure value added in the short run; value gained is not
matched with value given up
o Does not recognise investments (treated as a loss in value)
o FCF is a liquidity concept as it can be bolstered through cutting back on investments

CAPM
Pros

Captures the existence of a positive risk for return trade off

Simple easily stress tested to derive a range of possible outcomes to provide confidence around the
required rates of return
Systemic risk (beta) CAPM takes account of this, and this is important as this is often unforeseen
and cannot be completely mitigated
Business risk and financial variability when business investigate opportunities, if the financing
differ than WACC would not work, but CAPM would

Cons inherent within the inputs and assumptions

Risk free rate yield changes daily, hence creating volatility
Return on market sum of capital + dividends for the market, issues arise when this is negative, and
that these returns can be backward looking and not representative of future market returns
Requires accurate measurement of the market risk premium, which has inherent volatility
Beta is not overly accurate at predicting returns e.g. low beta firms tend to perform better than
CAPM predicts and vice versa

WACC
Rate provided to a company on average to all security holders for financing its assets
Pros

Simple and easy

Single rate for all projects saves a lot of time if projects hold the same risk profile and there is no
change in the proposed capital structure
Decisions can arrive at a faster pace and new opportunities can be grabbed as the rate can be used
across numerous projects

Cons

Market value of equity is not static hence it can create substantial variations in the true cost of capital
hence resulting in inaccurate estimates
Difficulty in maintaining the capital structure same capital structure for two projects is unlikely:
o Fund projects through retained earnings, limitation in this case is that companys may not
have available free cash flow
o Raising fund in the same capital mix, difficult to receive funds at the same terms (dependent
on market) and the primary focus of management is to reduce cost of capital as low as
possible to achieve the shareholders profit and wealth maximisation