valuesurvey - 1 Valuation Approaches and Metrics A Survey...

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Valuation Approaches and Metrics: A Survey of the Theory
and Evidence
Aswath Damodaran
Stern School of Business
November 2006

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Valuation Approaches and Metrics: A Survey Article
Valuation lies at the heart of much of what we do in finance, whether it is the
study of market efficiency and questions about corporate governance or the comparison
of different investment decision rules in capital budgeting. In this paper, we consider the
theory and evidence on valuation approaches. We begin by surveying the literature on
discounted cash flow valuation models, ranging from the first mentions of the dividend
discount model to value stocks to the use of excess return models in more recent years. In
the second part of the paper, we examine relative valuation models and, in particular, the
use of multiples and comparables in valuation and evaluate whether relative valuation
models yield more or less precise estimates of value than discounted cash flow models. In
the final part of the paper, we set the stage for further research in valuation by noting the
estimation challenges we face as companies globalize and become exposed to risk in
multiple countries.

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Valuation can be considered the heart of finance. In corporate finance, we
consider how best to increase firm value by changing its investment, financing and
dividend decisions. In portfolio management, we expend resources trying to find firms
that trade at less than their true value and then hope to generate profits as prices converge
on value. In studying whether markets are efficient, we analyze whether market prices
deviate from value, and if so, how quickly they revert back. Understanding what
determines the value of a firm and how to estimate that value seems to be a prerequisite
for making sensible decisions.
Given the centrality of its role, you would think that the question of how best to
value a business, private or public, would have been well researched. As we will show in
this paper, the research into valuation models and metrics in finance is surprisingly
spotty, with some aspects of valuation, such as risk assessment, being deeply analyzed
and others, such as how best to estimate cash flows and reconciling different versions of
models, not receiving the attention that they deserve.
Overview of Valuation
Analysts use a wide spectrum of models, ranging from the simple to the
sophisticated. These models often make very different assumptions about the
fundamentals that determine value, but they do share some common characteristics and
can be classified in broader terms. There are several advantages to such a classification --
it makes it is easier to understand where individual models fit in to the big picture, why
they provide different results and when they have fundamental errors in logic.