Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

SINGLE-PHASE NO-GROWTH MODEL

The simplest valuation model deals with a company that has a stable level of current earnings but a total absence of any investment prospects that could generate returns in excess of the cost of capital. In this simplest of all cases, the well-known result is

where P is the firm’s intrinsic value, E is the fixed level of earnings, and k is the cost of capital. In this “no-growth” example, all earnings are being paid out as dividends.2 Clearly, the very notion of a constant earnings stream is artificial. Nonetheless, this simple case serves handily as a convenient starting point for the analysis of more-complex multiphase growth models. In particular, the constant-earnings assumption forms the basis for the treatment of the terminal phase in many valuation models.

To deal with the question of the earnings progression under a specific form of competitive equilibrium and the ultimate impact that such a state would have on the company’s valuation, the first step is to recast the problem in sales-driven terms. In the terminology of sales-driven franchise value (Leibowitz 1997a), the constant-earnings model can be rewritten as

where S is (constant) annual unit sales and m is net margin. (For simplicity, assume a regime without taxation.) The earnings and sales ...