CHAPTER 1

AN OVERVIEW
1. It is impossible to Forecast accurately the future cash flows that the business would generate and estimate
precisely the discount rate applicable to the future cash flows.
2. A business is not worth the same to different parties. Different prospective buyers are likely to assign different
values to the same company, depending on how the company fits into their scheme of things.
3. The primary objective of management should be to maximise shareholder value.
4. The purpose of corporate valuation is basically to estimate a fair market value of a company
5. Fair Market Value - “the price at which the property would change hands between a willing buyer and a
willing seller when the buyer is not under any compulsion to buy and the seller is not under any compulsion to
sell, both parties having reasonable knowledge of relevant facts.”
CONTEXT OF VALUATION
Corporate Valuation is done in the following situations:
1. Raising capital for a nascent venture – Raising capital for venture capitalist and private equity firms.
2. Initial Public Offering – to find out at what price the IPO should be made.
3. Acquisions – Takeovers, mergers (absorption or consolidation) and purchases of business divisions.
4. Divestitures – sale of a particular division or a plant. Same as purchase of Business divisions.
5. PSU Disinvestment – Dilution in Public Sector Undertakings.
6. ESOPs – Employee stock options plan – to determine the exercise price – when company is unlisted
7. Portfolio Management – valuation depends on the investment philosophy of the investor.
APPROACHES TO VALUATION
1. Book value approach - simplest approach - book value figures are adjusted to reflect replacement value or
liquidation value or fair value – discrepancy arises because – conventional balance sheet does not reflect value
of intangible assets – such as brand equity – technical and managerial knowledge.

2. Stock and Debt Approach – when securities are publicly traded – value can be obtained by – adding the
market value – of all its outstanding securities. – also referred to as market approach – assumes market
efficiency – efficient market is when the market price of security is an unbiased estimate of its intrinsic value.

3. Discounted Cash Flow Approach – involves forecasting future cash flows and discounting the same to
present point of time. – using the cost of capital that reflects the firm’s capital structure and business risk –
several model of DCF valuation – enterprise DCF model (Involves FCFF (Free cash flow to firm), WACC
(weighted average cost of capital)) – equity DCF model – adjusted present value model. - Economic profit
model

4. Relative Valuation approach – one can teel the value of an asset by looking at the price of similar assets –
there are two multiples – Enterprise Multiples and Equity Multiples.

5. Option Valuation approach - the option valuation approach utilizes the principles of option pricing theory to
estimate the value of a company or its securities - Treats the company like an option on its underlying assets,
acknowledging the inherent uncertainty and future potential.

FEATURES OF THE VALUATION PROCESS

The valuation process involves understanding and managing three key aspects: bias, uncertainty, and complexity.
Bias in Valuation:
* Analysts often bring preconceptions to the table, influenced by prior knowledge, market prices, and external
pressure.
* These biases can lead to optimism or pessimism in defining inputs like operating margin, ROIC, growth rate, and
cost of capital.
* To minimize bias, analysts should avoid precommitments, decouple valuation from rewards/punishment, diminish
institutional pressures, and increase self-awareness.
Uncertainty in Valuation:
* Estimation errors arise from translating raw information into inputs and using those inputs within valuation models.
* Company-specific uncertainty stems from potential misjudgement of firm's future performance.
* Macroeconomic uncertainty arises from changes in economic conditions affecting the value.
* Responses to uncertainty include building better valuation models, providing valuation ranges instead of single
values, and expressing valuations in probabilistic terms.
Complexity in Valuation:
* Advances in technology and accessibility of information have led to increasingly intricate valuation models.
* However, this complexity brings challenges such as information overload and difficulty understanding the inner
workings of the models.
* To address these issues, analysts should adhere to principles of parsimony, choosing simpler explanations and
models whenever possible.

Overall, recognizing and addressing these elements helps improve the accuracy and reliability of valuation efforts. It is
essential to remember that the utility of valuation does not depend solely on achieving perfect precision; rather, it
relies on relative precision compared to other valuers attempting to assess the same company.

CORPORATE VALUATION PRACTICES

Corporate valuation practices involve three main approaches: relative valuation, transaction multiples, and discounted
cash flow (DCF) valuation.
Relative Valuation:
* Based on multiples of comparable companies, commonly used for Initial Public Offering (IPO) pricing.
* Allows comparison between the company being valued and publicly traded peers.
Transaction Multiples Method:
* Used alongside DCF in Mergers & Acquisitions (M&A) analysis.
* Reflects multiples paid for similar transactions, ensuring both parties acknowledge relevant comparisons.
Discounted Cash Flow Valuation:
* Forecasts future cash flows and applies a discount rate to determine present value.
* Typical approach includes considering free cash flows during planning periods (e.g., 5–10 years) and estimating a
terminal value using relative valuation methods.
Growing Consensus on Professional Standards:
* Since the mid-1990s, there has been increasing agreement among professionals regarding business valuation
standards.
* This development coincides with proliferation of business valuation educational programs.
* Conformity to established standards is now expected by stakeholders including owners, investors, courts, and
regulatory bodies.

INFORMATION NEEDED FOR VALUATION

 1. Industry and Competition - Market size • Market trends • Market structure • Characteristics of competitors •
Nature of competition
2. Operations - Production capacities • Products/services • Cost structure • Suppliers • R&D • Quality control
3. Marketing and Sales - Customer base • Marketing and sales organization - Sales trends, domestic and
international • Pricing policies • Advertising and promotion
4. Human Resources - Employee strength • Compensation policies
5. Historical Financial Information - Historical income statements • Historical balance sheets • Historical
statements of cash flow • Notes to accounts (including significant accounting policies) • Information on all
exceptional and extraordinary items
6. Financial Projections - Projected income statement for the next five years • Projected balance sheet for the
next five years • Projected cash flows for the next five years • Assumptions underlying financial projections.

REFINEMENTS IN VALUATION
Refinements in valuation practices have evolved significantly, driven by the lessons learned from the disappointing
outcomes of mergers and acquisitions in the 1980s.
Enhancements in Valuation Techniques:
* Access to online public filings and data from organizations like Factset and Ibbotson Associates has revolutionized
the availability of information for valuation.
* Improved data accessibility allows for more comprehensive due diligence and refined Discounted Cash Flow (DCF)
analysis.
* Advancements in methodologies like the Fama-French three-factor model have enabled capturing additional factors
like size and price-book ratio.
Increased Reliance on DCF Models:
* Companies like Colgate-Palmolive have embraced DCF for global investment evaluations due to its ability to
provide a common denominator for assessing transactions across diverse markets.
* Better DCF forecasts have facilitated more complex M&A financing structures such as mezzanine financing and
contingent convertible bonds by enabling lenders to evaluate risks accurately
Challenges in Valuation:
* Despite advancements, challenges persist, including imprecise estimation of synergies and potential manipulation of
numbers to justify deals desired by CEOs.
* Thomas Lys highlights that sometimes valuation can be used as a mere justification for deals desired by CEOs,
emphasizing the importance of transparency and integrity in the valuation process.

JUDICIAL REVIEW AND REGULATORY OVERSIGHT ON VALUATION

Regulatory oversight and judicial review play significant roles in valuation processes related to corporate transactions
such as mergers, takeovers, preferential allotments, and more.
Key Points:
* Preferential allotments by listed companies are regulated by SEBI.
* Determination of fair value for transferring shares to non-residents in India requires the usage of the DCF method
and must be performed by a Chartered Accountant or SEBI-registered Category 1 merchant banker.
* Open offers under the SEBI Takeover Code are subject to regulation.
* Judicial review of valuation occurs in merger petitions submitted to the court.
* Various entities, including minority shareholders, creditors, the central government, SEBI, or revenue authorities,
can challenge proposed valuations in court for judicial review.
Court Intervention:
* Courts maintain that valuation is primarily a technical exercise best left to experts.
* Courts intervene only when valuation is flawed or unfair.
* In GL Sultania v. SEBI, the Supreme Court stated that valuation cannot be challenged unless it is proven to be
fundamentally incorrect, contain patent mistakes, adopt a demonstrably wrong approach, or commit a fundamental
error.
Conventional Acceptable Methods:
* Listed companies' market prices on the valuation date are crucial, particularly for actively traded firms.
* Profitability and dividend records matter for unlisted companies.
* Listed surrogates may be referenced if needed.
* In cases concerning winding up, asset-based valuation utilizing break-up value is widely employed.

INTRINSIC VALUE AND THE STOCK MARKET

Valuation theories and their relation to the stock market's dynamics have sparked considerable debate regarding the
role of emotional influences and the effectiveness of traditional valuation techniques.
Divergences Between Valuation Approaches and Market Prices:
* Long-term convergence exists between fundamental values and market prices, although temporary disparities occur.
* Higher Return on Invested Capital (ROIC) and growth rates correlate positively with higher market values.
* Despite the importance of reported financial results, the stock market tends to focus on a company's underlying
economic performance.
The Role of Emotions and Market Efficiency:
* Although the stock market is generally efficient, it remains susceptible to mispricing and irrational behaviours.
* Positive feedback loops cause bubbles, characterized by rapid increases in asset prices followed by sudden declines.
* Corrections to mispricing’s usually happen quickly, with market-wide deviations being resolved within a few years.
Model of Stock Pricing:
* Two categories of investors shape stock prices—informed investors and noise traders.
* Informed investors base decisions on fundamental analysis, whereas noise traders act impulsively.
* The interactions between informed investors and noise traders create price fluctuations around intrinsic value, with
corrections happening as informed investors adjust their positions.
Implications for Managers:
* Focus on long-term economic fundamentals instead of short-term accounting manipulations.
* Avoid fixation on bonus issuances, stock splits, or listing changes, as these do not affect core business fundamentals.
* New accounting standards should not impact share prices significantly since they do not alter underlying economics.
Limitations and Challenges:
* Traditional valuation approaches may struggle to explain extreme market events caused by irrational behaviours.
* Behavioural finance perspectives offer valuable insights into understanding market anomalies, but empirical
evidence varies depending on specific contexts.

Overall, despite the challenges posed by human emotions and irrational behaviours, valuation theories remain
essential tools for understanding and predicting stock prices. However, acknowledging the limitations of these theories
helps practitioners develop a nuanced perspective that incorporates behavioural aspects alongside traditional valuation
frameworks.
IMPORTANCE OF KNOWING INTRINCIC VALUE
Understanding intrinsic value holds significant importance for corporate managers due to the stock market's tendency
to correct mispriced securities over time. By focusing on intrinsic value, managers can leverage opportunities
presented by market deviations while mitigating potential risks.
Key Implications of Knowing Intrinsic Value:
* **Issue Additional Share Capital**: If the share price is deemed excessive compared to intrinsic value, managers
can issue additional shares without diluting existing shareholders' ownership excessively.
* **Buy Back Shares**: When the share price is below its intrinsic value, managers can repurchase shares, increasing
the proportion of outstanding shares owned by remaining shareholders.
* **Pay for Acquisitions With Shares Instead of Cash**: During times of overvaluation, paying for acquisitions using
shares rather than cash can help avoid unnecessary expenditure of scarce resources.
* **Divest Particular Businesses**: Selling underperforming divisions or subsidiaries becomes viable when trading
multiples are disproportionately high compared to their true worth.
Consequences of Ignoring Value:
Ignoring intrinsic value can have serious adverse consequences, as the following conspicuous examples suggest:
∑ The rise and fall of business conglomerates in the 1970s.
∑ Hostile takeovers in the US in the 1980s.
∑ The collapse of Japan’s bubble economy in the 1990s.
∑ The Southeast Asian crisis in 1998.
∑ Internet bubble
∑ The economic crisis starting in 2007.
∑ The ambitious global leveraged acquisitions by Indian firms.

ENTERPRISE DCF MODEL

The traditional methods of book value approach and relative valuation have been surpassed since the early 1990s by
the increasing prominence of the discounted cash flow (DCF) approach, particularly the Enterprise DCF Model. This
shift occurred due to its perceived conceptual superiority and support from prominent consulting firms like McKinsey
and Company.
Unlike valuing a capital project with finite life, valuing a firm through the DCF approach considers it as having
infinite life without defining an economic life or imputing a salvage value to its assets. Additionally, while a capital
project is often seen as a one-time investment, valuing a firm involves taking into account all future investments in
fixed assets and net working capital necessary to maintain growth.
In summary, valuing a firm via the DCF approach requires forecasting cash flows over an indeterminate period for a
company that is anticipated to grow continuously. This task can be challenging, but practical approaches help address
the complexity involved.

Thus, the discounted cash flow approach to valuing a firm involves the following steps:

1. Analyzing historical performance

2. Estimating the cost capital
 3. Forecasting performance
4. Determining the continuing value
5. Calculating the firm value and interpreting the results.

Decomposing Revenue Growth

1. Organic revenue growth
2. Acquisitions and divestitures
3. Currency effects
4. Changes in accounting policies
General Guidelines for Historical Analysis
 Consider a period of at least 10 years or more
 Disaggregate ROIC and revenue growth, the two principal value drivers, into their key components

Cost Of Capital
The cost of capital is the discount rate used for converting the expected free cash flow into its present value. It
• Represents the weighted average of the costs of all sources of capital
• Is calculated in post-tax terms
• Is defined in nominal terms
• Is based on market value weights
• Is adjusted for risk

WACC FORMULA
The formula that may be employed for estimating the weighted average cost of capital is:
WACC = rE (S/V) + rP (P/V) + rD(1-T) (B/V)
where WACC = weighted average cost of capital
rE = cost of equity capital
S = market value of equity
V = market value of the firm
rp = cost of preference capital
P = market value of preference capital
rD = pre-tax cost of debt
T = marginal rate of tax applicable
B = market value of interest-bearing debt
Forecasting Performance
1. Determine the length of the explicit forecast period.
2. Develop a strategic perspective on the future performance.
3. Develop financial forecasts.

Develop Financial Forecasts

 The DCF value of an enterprise depends on forecasted free cash flow and the latter is derived from the profit and
loss account and balance sheet. So, the forecasting process may be broken down into the following steps:
1. Develop the sales forecast. – Top down or Bottom-up Approach.
2. Forecast the profit and loss account. – determine economic driver – estimate forecast ratio – multiply both.
3. Forecast the balance sheet: the assets side. – stock approach or flow approach
4. Forecast the balance sheet: the liabilities side. – keep paid up capital unchanged – estimate reserves and
surplus – forecast existing debt -
5. Calculate ROIC and FCF.
6. Check for consistency and alignment.

Determining The Continuing Value

As discussed earlier, a company’s value is the sum of two terms:
Present value of cash flow during + Present value of cash flow the explicit forecast period after the explicit
forecast period
The second term represents the continuing value or the terminal value. It is the value of the free cash flow beyond
the explicit forecast period. Typically, the terminal value is the dominant component in a company’s value. Hence, it
should be estimated carefully and realistically.
There are two steps in estimating the continuing value:
• Choose an appropriate method – cash flow methods and non-cash flow methods.
• Calculate the continuing value

 NOPLAT - NOPLAT must be based on a normalized level of revenues and a margin and ROIC which are
sustainable
 ROIC - The expected ROIC should reflect the expected competitive conditions
 Growth Rate - Real long-term growth rate for the industry plus inflation
 WACC -WACC must reflect the underlying business risk and a sustainable capital structure

Some Misconceptions about Continuing Value

There are three common misconceptions about continuing value.
 The length of the explicit forecast period has a bearing on value.
 Most of the value is created during the continuing value period.
 Competitive advantage period ends at the end of the explicit forecast period.

Non-Cash Flow Methods

  Multiples method
 Replacement cost method
 Liquidation value method

Multiples Method
 Enterprise Value – to – EBITDA Ratio
 Enterprise Value – to – Book Value Ratio
 Enterprise Value – to – Sales Ratio

REPLACEMENT COST METHOD

 A simple yet direct way to estimate the value of an asset or project by determining the cost of replacing it with
a new or similar counterpart. Advantageous due to ease of application but lacks consideration of revenue
generation, demand/supply dynamics, or emotional value.
LIQUIDATION VALUE METHOD
**Liquidation Valuation:** Estimates the value of a company's assets if they were rapidly sold in a forced liquidation scenario,
excluding intangibles. Used in bankruptcies or to understand the lowest possible value of a company.

**Going Concern Value:** - Represents the value of a business expected to operate profitably in the future, incorporating
intangible assets and growth potential. Higher than liquidation value, crucial for accurate valuation of operational businesses.

CALCULATING VALUE AND INTERPRETING RESULTS

This involves the following steps:
. Determine the value of operations
. Calculate the enterprise value and equity
value
. Explore multiple scenarios
. Verify valuation results
Value under Multiple Scenario
1. As risk and uncertainty characterize most business decisions, you must think of scenarios and ranges of value,
reflective of this uncertainty
2. When you analyze the scenarios, critically examine your assumptions with respect to the following: broad
economic conditions, competitive structure of the industry, internal capabilities of the firm, and financing
capabilities of the company.

STARTEGY ANALYSIS
1. Strategy analysis involves industry analysis, competitive strategy analysis, and corporate strategy analysis.

INDUSTRY ANALYSIS
PORTERS 5 FORCE MODEL
Threat of new entrants • Rivalry among existing firms • Pressure from substitute products • Bargaining power of
buyers • Bargaining power of sellers

Value Chain Analysis

Analyses a company's internal activities to reveal strengths, weaknesses, and opportunities for improving
competitiveness through better resource allocation and optimization of primary and support functions.
Modern Value Chain

- **Customer Priorities:** Companies should adapt their activities based on changing customer needs and
priorities.
- **Channels:** Technology is reshaping distribution channels, like the Internet transforming financial services
distribution.
- **Offering:** Products/services should align with customer needs and be delivered through suitable channels.
- **Inputs/Raw Materials:** Secure supply of raw materials is vital; strong supplier relationships can create a
virtual value chain.
- **Asset/Core Competency:** Company activities determine required assets and core competencies; e.g., Nike
focuses on design and marketing, outsourcing manufacturing to focus on core strengths.

RELATIVE VALUATION
1. CONSIDERED AS A SUBSTITUTE TO DCF. –
STEPS INVOLVED IN RELATIVE VALUATION
1. **Analyze the Subject Company:** Conduct a thorough analysis of the subject company's competitive and
financial position, covering aspects like product portfolio, market segments, technological capabilities, and
financial performance indicators.
 2. **Select Comparable Companies:** Identify companies similar to the subject company in terms of business
lines, market served, and scale of operations. Compare at least 3 to 4 closely related companies from a pool of 10
to 15 industry peers.
3. **Choose Valuation Multiples:** Utilize various valuation multiples such as price-earnings ratio,
EV/EBITDA ratio, and EV/sales ratio. Select two to three multiples that best suit the valuation task at hand.
4. **Calculate Valuation Multiples for Comparable Companies:** Determine valuation multiples for
comparable companies based on their financial attributes like sales, EBITDA, book value of assets, and enterprise
value.
5. **Value the Subject Company:** Apply the average multiples of comparable companies to relevant financial
attributes of the subject company to estimate its enterprise value. Consider growth prospects, risk factors, and size
in determining appropriate multiples for accurate valuation.

EQUITY VALUATION MULTIPLES

The P/E (Price-to-Earnings) multiple is a widely used valuation measure in equity analysis. It is calculated as the
market price per share divided by earnings per share. Reasons for using the P/E multiple include its focus on earning
power, empirical evidence showing that low P/E stocks tend to outperform the market, and its importance in security
valuation[1].

The P/B (Price-to-Book) multiple, another common valuation measure, is calculated by dividing the market price per
share by the book value per share. The book value per share is derived from the balance sheet and represents
shareholders' equity divided by the number of outstanding equity shares. Reasons for using the P/B multiple include
its stability compared to EPS and its relationship to long-term average returns[1].

The P/S (Price-to-Sales) multiple has gained attention as a valuation tool in recent years. It is calculated by dividing a
company's stock price by its revenue per share or market value of equity capital by annual sales. The P/S multiple
reflects what the market is willing to pay per unit of sales revenue. Reasons for using the P/S multiple include its
stability compared to EPS, less susceptibility to manipulation, and positive nature even when EPS is negative.
Empirical evidence suggests that differences in the P/S multiple are related to long-term average returns[1].
The choice of multiple in valuation can significantly impact the estimated value of a company. Aswath
Damodaran presents three approaches to selecting a multiple: the Cynical View, the Bludgeon View, and the
Best Multiple.

### Cynical View:

- **Approach**: Choose a multiple that aligns with preconceived notions, potentially maximizing or minimizing the
value based on intentions to sell or buy.
- **Guarding Against Bias**:
- Delegate valuation tasks cautiously to prevent bias.
- Question the impact of using different multiples or comparables in a valuation report.

### Bludgeon View:

- **Approach**: Utilize multiple multiples to value a company and then consolidate findings.
- **Methods**:
- Generate a range of values from various multiples.
- Calculate a simple average of values from different multiples.
- Compute a weighted average considering the precision of each value.
### Best Multiple:
- **Approach**: Opt for the most suitable multiple for the firm being valued.
- **Ways to Determine**:
- **Fundamental Approach**: Use variables highly correlated with the firm's value.
- **Statistical Approach**: Regress each multiple against fundamental factors affecting value.
- **Conventional Approach**: Select commonly used multiples based on specific sectors or situations.

In practice, different multiples like P/E, P/B, EV/EBITDA, and EV/sales are recommended for specific types of firms
based on their characteristics and financial structures[1][2]. Each multiple has its advantages and drawbacks, making
it crucial to choose wisely based on the nature of the business being valued.
### Best Practices for Using Multiples

1. **Consistent Definition**: Ensure that multiples are defined consistently across firms being compared.
2. **Similar Growth and Profitability Prospects**: Select comparables with similar growth and profitability prospects
to the firm being evaluated. Adjustments may need to be made due to differences between firms.
3. **Identifying Fundamental Determinants**: Understand what drives each multiple and how variations in those
fundamentals affect the value of the multiple.
4. **Forward-Looking Estimates**: Utilize multiples based on projected profits or cash flows rather than historical
data.
5. **Preference for Enterprise Value Multiples**: Opt for multiples that consider total enterprise value instead of only
equity value, such as EV/EBITDA over Price/Earnings (P/E).

### Assessment of Relative Valuation

Relative valuation methods, while not as theoretically sound as discounted cash flow (DCF) approaches, remain
widely employed due to convenience and ease of interpretation. They often involve comparing a company's valuation
metrics against industry averages or peer group medians. However, this naïve comparison can lead to incorrect
conclusions without considering other important factors affecting multiples, including growth prospects, profitability,
risk, capital structure, accounting policies, and corporate governance standards.

Despite the challenges associated with relative valuation, it remains popular among practitioners due to its simplicity
and effectiveness as a communication tool. It allows analysts to quickly convey their findings and justify valuations,
especially when time constraints limit the development of comprehensive cash flow models. Additionally, relative
valuation serves as a helpful sanity check, allowing analysts to assess whether a company's implied multiple aligns
with its peers and to explore potential explanations for any discrepancies[1].

Relative valuation, despite the convincing logic of Discounted Cash Flow (DCF) analysis, is popular due to its
simplicity and ease of communication. Earnings multiples are commonly used in equity research and investment
banking because they provide a quick way to compare companies based on similar expected performance metrics like
ROIC, growth, and risk. While DCF requires detailed projections and subjective forecasts, multiples offer a
convenient shortcut for valuation by assuming companies with similar characteristics should have similar multiples.

However, using industry average multiples can be misleading as companies differ in various factors like growth
prospects, profitability, risk, and governance standards. Adjusting for these differences requires significant effort.
Despite this, multiples remain popular as they are easier to communicate and defend compared to DCF analysis.
Relative valuation is market-driven and seen as more objective, making it commonly used in fairness opinions and
legal cases.

On the other hand, relative valuation has weaknesses. It allows for greater manipulation as underlying assumptions are
not explicitly defined, potentially leading to biased valuations. Additionally, using market-derived multiples can
perpetuate valuation errors present in the market, affecting the accuracy of valuations compared to firm-specific DCF
analysis[1].

CHAPTER 4
Book Value Approach
 The simplest approach to valuing a firm is to rely on the information found on its balance sheet.
 Two equivalent ways of using the balance sheet information to appraise the value of a firm.
1. Book values of investor claims may be summed directly.
2. The assets of the firm may be totaled and from this total, non-investor claims may be deducted.

Reasons for Divergence Between Book Values and Market Values

 Inflation
 Technological changes
 Organisational capital

Market Inefficiency and Valuation

 To be useful in practice, it is necessary to have documented and predictable inefficiencies that valuers can
incorporate in their valuation analysis.
 It is one thing to admit the possibility of market inefficiency, but it is another think to agree on how the valuer
can quantify the effect of inefficiency on valuation.

Bottom Line
 Although the market may not be perfectly efficient, no other pricing mechanism seems to be consistently
better.
 “.. democracy.. worst form of government except all other forms that have been tried from time to time.”

Strategic Approach to Valuation

The DCF approach is widely used in valuing companies because it is conceptually sound and consulting firms have
developed practical methodologies for applying it. However, it suffers from certain limitations. To a great extent
these limitations can be overcome by using the strategic approach to valuation along with the DCF approach to
valuation.

Limitations of the DCF Approach

1. It mixes reliable information (usually near-term cash flow information) with unreliable information (terminal
value). It is an axiom of engineering that a combination of good information and bad information does not
result in information does not result in information of average quality. Rather, the bad information.
2. It discards a great deal of information that is relevant for calculating the value of a company.
3. It relies on assumptions that are difficult to make but ignores assumptions that can be made with greater
confidence.