Academic journal article UTMS Journal of Economics

Fundamental Analysis and Discounted Free Cash Flow Valuation of Stocks at Macedonian Stock Exchange

Academic journal article UTMS Journal of Economics

Fundamental Analysis and Discounted Free Cash Flow Valuation of Stocks at Macedonian Stock Exchange

Article excerpt


Valuation of an asset can be determined on three ways. First, as the intrinsic value of the asset, based on its capacity to generate cash flows in the future. Second, as a relative value, by examining how the market is pricing similar or comparable assets. Finally, we can value assets with cash flows that are contingent on the occurrence of a specific event as options (Damodaran 2006).

The basic idea of intrinsic valuation is that, the value of any asset is the present value of the expected future cash flows on the asset, and it is determined by the magnitude of the cash flows, the expected growth rate in these cash flows and the uncertainty associated with receiving these cash flows. There are two wide used models based on discounted cash flows (Dividend Discount Model-DDM as well as Discounted Cash Flow Model-DCF) in order to determine stock intrinsic value. In this paper we use discounted free cash flow techniques for stocks' valuation at Macedonian Stock Exchange (MSE). DCF valuation faces the choice: to make equity valuation (value just the equity claim in the buiness) or the firm valuation (value the entire business). We use Discounted Free Cash Flow to Firm model for company valuation in order to evaluate value of all investment opportunities of the firm compared with available cash flows that can be directed both to shareholders or creditors.

Relative valuation is based on using standardized market values as multiplies of some standard variable as earnings, book value and revenues and comparisons with valuation of similar assets/companies in order to determine if they have fair value or currently are underpriced or overpriced.

In their paper based on 104 analysts's reports (Demirakos, Strong, and Walker 2004) argued that analysts typically choose either a relative valuation models (P/E model) or an explicit multiperiod DCF valuation model as their dominant valuation model. However they found that none of the analysts use the price to cash flow as their dominant valuation model and some analysts who construct explicit multiperiod valuation models still adopt a comparative valuation model as their preferred model.

In accordance with the DCF method, the value of a company is a function of three major variables: the expected net cash flows, the expected growth of these cash flows, and the required rate of return. The net cash flows are the result of the company's in-come generating potential (or earning power) (Nenkov 2010). The future growth in earnings depends on the growth of this earning power. The required rate of return (or cost of capital) depends on the level of risk of the company's operations and its financial leverage. Finally, the value of the company can be expressed as a function of the earning power, the expected growth in earnings, and the level of risk (Damodaran 2006).

Kaplan and Ruback (1995) conclude that DCF valuations approximate around market prices reasonably well. There are also considerable numbers of papers that compare all three valuation models in order to determine their accuracy. In their paper Penman and Sougiannis (1998) contrasts dividend discount techniques, discounted cash flow analysis, and techniques based on accrual earnings when each is applied with finite-horizon forecasts. They provide evidence that valuation errors are lower using accrual earnings techniques rather than cash flow and dividend discounting techniques.

Market price is more closely related to long-term "expected earnings" (or "average earnings", or the "the earning power"), rather than to temporary deviations in current earnings, which are within the acceptable range. This fact outlines the close relationship between relative valuation and discounted cash flow valuation, since both are based on expected average earnings or cash flows in the long run (Nenkov 2010).

There is also growing uncertanity if DCF Models are suitable for emerging and transition economies. …

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