Firm valuation and its relevant models and approaches play a significant role in finance while at the same time expand to broader aspects, such as risk assessment. Most of the relevant literature is discussing valuation techniques in general, while other authors research mostly on the practical side of valuation. Some examples are Rosenbaum and Pearl (2013) and Koller, Goedhart and Wessels (2010), who discuss mainly about DCF (discounted cash flow), and other related techniques. Other academic papers examine the specific topic by focusing each on a certain method. For instance, Easton (1985) argues about the connection between fundamental financial data and market valuations to come to the conclusion that security prices are strongly related to the present value of future cash flows while Fernandez (2015) in his research concludes that different discounting methods for the same asset provide the same results.
Several researchers have also focused on the comparative analysis of the results regarding different valuation models. For instance, Penman and Sougiannis (1998) and Francis et al. (2000) and performed a comparative analysis of the dividend discount model (DDM), the DCF, and the residual income (RI) approaches to come to the conclusion that the residual income model is more accurate in terms of firm value estimates compared to the DCF and DDM models. However, this outcome is in contradiction to the fact that all three models are equivalents and, thus, they should yield the same value estimates. Therefore, their research concludes that those valuation models could produce different estimates only in the case they are applied incorrectly.
Sweeney (2002) among others shows that accrual accounting models, as the RI model, and cash flow models, like the FCF (Free Cash Flow) model, result to the same value as long as forecasts are internally consistent, and discount rates are consistent with the value additivity principal according to which a group of asset’s value is exactly equal to the resultant figure derived by adding the value of individual assets comprising the asset group.
The valuation models can be summarised in five main categories; liquidation and accounting valuation, contingent claim valuation, goodwill valuation, relative or multiple valuation and Discounted Cash Flow (DCF) valuation (Damodaran, 2006; Fernandez, 2002). Since all these five categories have different fundamentals of valuation, every model has its own characteristics, which could lead to the preference of one model over others. Next to the choice of a certain model based on underlying assumptions, Imam et al. (2008) describe that the popularity of models go through cycles and that model usage depends on preferences of the valuators’ clients.
According to Young et. al. (1999) each valuation method has its own advantages and disadvantages since it focuses on different aspects of the process. Therefore there is no best model that can be applied to all cases and the choice should be based on which has the most robust characteristics regarding data imperfections while in any case it would be suitable to value a company using more than one approach (Young, et. al., 1999).
2.1.1. Liquidation and accounting based valuation models
The liquidation and accounting valuation models value the existing assets based on accounting values (Damodaran, 2006a; Fernandez, 2002). The most important argument for using accounting based valuation models over discounted cash flow models is that (forecasted) cash flows are not certain, and thus the valuation –based on expected cash flows– has a larger chance to be inaccurate. For that reason, valuation models that are based on book values could be preferred (Damodaran, 2006).
Vélez-Pareja and Tham (2003) argue that, even though balance sheet based models are useful for managerial use, these models are problematic because they use values from the balance sheet and there is a big difference between valuing a collection of assets and valing a business (Damodaran, 2005). Besides, Fernandez (2002) argues that the perspective of accounting based models is static, since anything that is not incorporated on the balance sheet is not considered in the firm’s valuation (i.e. future potential). This leads to undervaluation of companies with high growth opportunities. Finally, balance sheet based models are indicated by analysts as “of less importance” (Imam et al., 2008), since for instance earnings can easily be inflated in the short term and because accounting profits are subjective.