Table of Contents
Question 1: DCF and Market Multiple approach
The Discounting cash flow approach to business valuation is used when a company wants to consider the present value of future cash flows of the business (Meitner, 2006). In this kind of valuation, the cash flows used are expected, and not already determined. Besides, this approach leads to the company managers making assumptions of a steady rate of cash flows of an asset in the future. However, the truth about any business environment is that it is not easy to accurately predict the future of the cash flows. Such difficulty is brought about by the fact that in the case of any cash flow problem, the accuracy in the valuation of the business assets is compromised. The predictability problems associated with the Discounting Cash flow approach to company valuation makes it not suitable for business valuation. However, the method is the best when there is certainty of the cash flows from the company assets.
The Market multiple approaches are the best for business valuation as compared to the discounting cash flow approach because it is informed by market benchmarking. In this approach, the value of a company is arrived at based on comparison with similar companies in the market. The comparison is made based on the similarity between a company’s risks, growth prospects, capital structures, and cash flow patterns (Meitner, 2006). In essence, a company that considers all the above similarities in the market before undertaking asset valuation is likely to achieve a high level of accuracy. The Market multiple approaches are good for a company that operates in a market with similar businesses.
Question 2: Free Cash Flows
Free cash flows show the performance of business regarding the extent to which its operating cash flows can pay for its capital expenditures. As such, the amount of a company’s free cash flows determines its ability to finance its liabilities and to attract investors (Stowe, 2007). It is possible that a company with a high amount of free cash is likely to continue being in business hence protect the interests of investors. Besides, investors are concerned with the stability of the company in which they invest. If the company is not stable, investors will withdraw their investments and transfer it to other stable companies. In this regard, it does not make sensed to buy stock in a company whose free cash flows are expected to be negative in future unless the duration is long enough for an investor to get dividends and transfer his investment before the negativity is experienced.
As mentioned above, the future stability regarding the free cash flows of a firm is a determinant of the investors’ willingness to put their money in a company’s stock. If negative free cash flows are expected, in a company, investors will not be willing to buy the company’s stocks and can even sell the stock they already have with the company. Therefore, it does not make sense to buy the stock of a company where the expected future free cash flows are negative.
- Meitner, M. (2006). The Market Approach to Comparable Company Valuation. Heidelberg: Physica-Verlag Heidelberg.
- Stowe, J. D. (2007). Equity asset valuation. Chichester: John Wiley.