Valuation: Measuring and Managing the Value of Companies, Fifth Edition

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Frameworks for Valuation

In Part One, we built a conceptual framework to show what drives value. In broad terms, a company’s value is driven by its ability to earn a healthy return on invested capital (ROIC) and by its ability to grow. Healthy rates of return and growth result in high cash flows, the ultimate source of value.

Part Two offers a step-by-step guide for analyzing and valuing a company in practice, including technical details for properly measuring and interpreting the drivers of value. Among the many ways to value a company (see Exhibit 6.1 for an overview), we focus particularly on two: enterprise discounted cash flow (DCF) and discounted economic profit. When applied correctly, both valuation methods yield the same results; however, each model has certain benefits in practice. Enterprise DCF remains a favorite of practitioners and academics because it relies solely on the flow of cash in and out of the company, rather than on accounting-based earnings. The discounted economic-profit valuation model is gaining in popularity because of its close link to economic theory and competitive strategy. Economic profit highlights whether a company is earning its cost of capital and how its financial performance is expected to change over time. Given that the two methods yield identical results and have different but complementary benefits, we recommend creating both enterprise DCF and economic-profit models when valuing a company.

Both the enterprise DCF and economic-profit ...