Valuation Approaches

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Valuation Approaches

Net Present Value (NPV) and Free Cash Flows (FCF) are similar in the sense that they are both used to determine the value of the business activity. The value of the business is linked to how much revenue a business generates and all the accumulated liabilities (Benamraou, Jory, Boojihawon, & Madichie, 2017). Revenues realized are used to pay back the stakeholders inform of dividends invested by introducing cash flows in the business.

However, NPV, FCF, and Dividends are different, in that they are applied to address a piece of other financial information about the business. NPV is a component of the cash flow (the difference between cash inflow and cash outflow) that has been discounted at certain rates to represent the firm’s future cash flows on the present terms by considering the time value of money or (Leyman et al., 2019). FCF, on the other hand, is simply a periodic difference between the revenues relished and the total expenses incurred. The net revenue from FCF is used by Discounted Dividend Models to pay back the shareholders from the assets invested for a specified period. Conversely, these models relate to each but serve different purposes.

NPV is applied by many investors and managers during the decision-making process to decide on the right and best project to pursue. NPV positive rule gives a direction to the investors that the proposed project will add value to the invested economic resources. FCF models are applied by companies that do not pay dividends, and maybe or not, whose earnings growth rate does not correspond to the dividend growth rate FCF is usually determined to asses and worth of business at an agreed period (Yeh & Lien, 2017). Dividend models are, however, the best used by large, stable, and mature public companies that promptly pay dividends. Dividend Models are applied when there is a need to pay a dividend to shareholders upon request at the end financial period or during the dissolution of a firm, and even the profits are in excess and not required to be used back into the business.

References

Benamraoui, A., Jory, S. R., Boojihawon, D. R., & Madichie, N. O. (2017). Net Present Value Analysis and the Wealth Creation Process: A Case Illustration. The Accounting Educators’ Journal, 26.

Leyman, P., Van Driessche, N., Vanhoucke, M., & De Causmaecker, P. (2019). The impact of solution representations on heuristic net present value optimization in discrete time/cost trade-off project scheduling with multiple cash flow and payment models. Computers & Operations Research, 103, 184-197.

Yeh, I. C., & Lien, C. H. (2017). Growth and value hybrid valuation model based on mean reversion. Applied Economics, 49(50), 5092-5116.