There are a variety of approaches to valuing a firm and its equity. The two most popular approaches are discounted cash flow (DCF) methods and market earnings multiple based methods.
Discounted cash flow methods generally project future expected cash flows, discount the value of each of those flows to present value using a discounted rate, and then take the sum of those discounted values to represent the total value of the firm or the total value of the equity. This Free cash flow to the firm (FCFF) method arrives at a total firm value. Free cash flow to equity (FCFE) values the total equity in a firm.
Market earnings multiple methods typically project out a future adjusted earnings amount for the next twelve months. This earning amount typically uses EBITDA (earnings before interest, taxes, depreciation, and amortization) or net income and then multiplies that earnings estimate by a multiple which is within the range of what other similiar firms have sold for in recent transactions.
Valuation Methods Synopsis
As one might expect, valuations can often become complex. The subject of the proper discount rate has spawned numerous books itself. Valuation can also bring up contentious issues, particularly when the ownership interest represents a controlling stake or there is a less than liquid market for that interest.
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