Fundamental Valuation Models

Why This Matters

Every valuation question on your finance exam ultimately asks the same thing: what is this asset worth today, and how do you prove it? These models aren't just formulas to memorize—they represent fundamentally different philosophies about where value comes from. Some models focus on cash flows, others on dividends, and still others on economic profit above the cost of capital. Understanding which model fits which situation is what separates a passing answer from a top-scoring one.

You're being tested on your ability to select the right tool for the job and defend that choice. An FRQ might give you a company profile and ask which valuation approach is most appropriate—and why alternatives fall short. Don't just memorize the formulas; know what assumptions each model makes, what inputs it requires, and when those assumptions break down. Master the logic behind each model, and the calculations will follow.

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Cash Flow-Based Models

These models value an asset by projecting its future cash flows and discounting them to present value. The core principle: an asset is worth the sum of all future cash it will generate, adjusted for the time value of money and risk.

Discounted Cash Flow (DCF) Model

• Projects future free cash flows and discounts them to present value—the foundational approach underlying most intrinsic valuation methods
• Uses WACC as the discount rate to reflect the blended cost of debt and equity financing
• Best for companies with predictable cash flows and sufficient operating history to make reliable projections

Free Cash Flow to Firm (FCFF) Model

• Captures cash available to all capital providers—both debt holders and equity shareholders—before financing decisions
• Calculated as operating cash flow minus capital expenditures, representing true cash-generating capacity
• Capital structure neutral, making it ideal when comparing firms with different debt levels

Free Cash Flow to Equity (FCFE) Model

• Isolates cash flows available only to equity holders—after debt payments, interest, and reinvestment needs
• Discounted at the cost of equity rather than WACC, since it reflects shareholder-specific returns
• Ideal for highly leveraged firms where debt significantly impacts what's left for shareholders

Adjusted Present Value (APV) Model

• Separates operating value from financing effects—calculates unlevered firm value first, then adds the present value of tax shields
• Explicitly models the benefit of debt financing through interest tax deductibility
• Best for complex capital structures or when financing arrangements change over time

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Dividend-Based Models

These models value equity by projecting future dividend payments. The underlying assumption: a stock's value equals the present value of all dividends it will ever pay.

Dividend Discount Model (DDM)

• Values stock as the present value of expected future dividends—the purest expression of shareholder cash returns
• Requires assumptions about dividend growth rates and an appropriate discount rate (cost of equity)
• Limited to dividend-paying companies with stable payout policies and predictable growth

Gordon Growth Model

• Assumes dividends grow at a constant rate forever—simplifying DDM to $P_0 = \frac{D_1}{r - g}$
• Only works when growth rate (g) is less than discount rate (r)—otherwise the formula produces nonsensical results
• Best for mature, stable companies in low-growth industries with consistent dividend histories

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Economic Profit Models

These models focus on value creation above the cost of capital. The key insight: generating profits isn't enough—a company creates value only when returns exceed what investors could earn elsewhere at similar risk.

Residual Income Model

• Measures income above the required return on equity—calculated as net income minus (equity × cost of equity)
• Values the firm as book value plus present value of future residual income—useful when cash flows are irregular
• Works for non-dividend payers since it relies on accounting earnings rather than cash distributions

Economic Value Added (EVA) Model

• Calculates operating profit minus the full cost of capital employed—expressed as $EVA = NOPAT - (Capital × WACC)$
• Focuses on managerial value creation by measuring whether operations generate returns above capital costs
• Useful for performance evaluation and incentive compensation, not just external valuation

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Market-Based and Asset-Based Models

These models derive value from external benchmarks or tangible assets rather than projected cash flows. The logic: comparable transactions and asset values provide market-validated reference points.

Comparable Company Analysis (Multiples)

• Values a firm by applying peer multiples like $P/E$, $EV/EBITDA$, or $P/B$ to the target's financials
• Reflects current market sentiment and provides a reality check against intrinsic models
• Quick but assumption-heavy—requires truly comparable peers and assumes the market prices them correctly

Asset-Based Valuation

• Sums the fair value of all assets minus liabilities—provides a liquidation or floor value
• Most relevant for asset-heavy industries like real estate, natural resources, or financial services
• Ignores going-concern value from operations, making it conservative for profitable companies

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Quick Reference Table

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Self-Check Questions

1. A company pays no dividends and has unpredictable cash flows but consistent accounting earnings. Which two models would be most appropriate, and why do DCF and DDM fall short?

2. Compare and contrast FCFF and FCFE: when would using FCFF give you a different perspective than FCFE, and which discount rate applies to each?

3. If an FRQ describes a mature utility company with 40 years of steady 3% dividend growth, which model offers the simplest appropriate valuation? What assumption must hold for the formula to work?

4. Why might an analyst use both DCF and Comparable Company Analysis on the same target? What does each approach reveal that the other might miss?

5. A private equity firm is evaluating a target with significant debt and plans to restructure its capital over five years. Which model best handles changing financing effects, and how does it separate operating value from tax benefits?