Alternatively, if the
company’s debt is not traded, Damodaran (2012) suggests the estimation of a
“synthetic rating”. This method relies on the comparison between interest
coverage ratios and associated credit rating spreads.
Finally, the cost of debt
is multiplied by one minus the marginal tax rate to arrive at the after-tax
cost of debt.
The basic concept behind
relative valuation or multiples is that identical assets should sell for
identical prices (Koller et al., 2015). This method is considered easy to
understand, apply and communicate. However, multiples are often misapplied.
According to Damadoran (2012) and Goedhart et al. (2005), relative valuation
presents major shortfalls. First, market trading levels may be dependent on
periods of irrational investor sentiment that will bias the valuation of the
company either too high or low in comparison to similar companies. Second, this
method can be easily manipulated. Different assumptions in the choice of the
multiple metrics or peer group can result in distinct conclusions. Nonetheless,
Fernández (2001) and Goedhart et al. (2005) agree that multiples provide useful
insights in stress-testing the DCF model and knowledge about industry dynamics
and its players.
Fernández (2001) divides
multiples into three categories. The first is based on the firm’s market
capitalization and include the price-to-earnings (P/E), price-to-equity book
value (P/BV) and price-to-sales (P/S) ratios. Although widely used, Goedhart et
al. (2005) pinpoint two major flaws in using P/E multiples: they are constantly
affected by capital structure and are impacted by nonoperating items, such as
one-time events. The second category is based on enterprise value (EV). The
most common include the EV-to-EBITDA, EV-to-EBIT, and EV-to-Revenues. Finally,
price-to-earnings growth or EV-to-EBITDA growth multiples are included in the
last category, alluded to growth. These ratios are then multiplied by the
company’s performance figures to estimate its share price.
Additionally, Goedhart et
al. (2005) present four principles to properly value a company using multiples.
First, the authors stress the importance of choosing peers with similar expectations
regarding ROIC and growth. Second, they defend that the EV-to-EBITA ratio is
superior to others since it is not affected by capital structure, unless
material changes to the cost of capital occur, thus providing “a more
apples-to-apples comparison” across company values (Koller et al., 2015).
Third, they suggest the adjustment of this ratio for nonoperating items such as
excess cash, operating leases, employee stock options and pensions. Lastly,
they advise the use of forward-looking multiples based on “forecast rather than
2.2.2 Peer Group
Choosing the right peer
group is crucial for a reasonable relative valuation. The relevant comparable
companies must have similar business models and operations. Moreover, these
companies must compete in the same markets, be exposed to the same
macroeconomic environment and have similar prospects of growth and returns on
capital (Foushee et al., 2012).
In consonance with
Fernández (2001), the flexibility to delay an investment has value in itself
and the real options approach tries to capture that while other methods such as
the net present value and internal rate of return fail to do so. Disregarding
this flexibility causes the undervaluation of lucrative projects (Fernández,
2001, and Michaels and Leslie, 1997).
classifies real options by categorizing them into three groups: contractual
options, growth/learning options, and flexibility options. To value real
options, both the Binomial and Black-Scholes models can be used (Fernández,
However, Damodaran (2012)
notes that there are constraints on the use of option-pricing models. The
constraints arise from the fact that assumptions need to be made over long
periods of time, decreasing the precision of the estimation significantly.
Every company has its own
characteristics so there is no single model that is able to accommodate all of
those characteristics. This literature review allowed the determination of the
best model to value ATVI. Therefore, the enterprise-DCF and EP models were the
primary choices due to their wider influence and insight about economic
performance. Also, ATVI is assumed to maintain a stable capital structure going
forward. Finally, the relative valuation approach was also implemented as a
complementary exercise to further robust the enterprise-DCF model. Hopefully,
this review is able to present the major valuation models and, by recognizing
their disadvantages, lay the foundation for further improvement in this