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

PRINCIPLE OF ONE VALUE

To consider how the principle of one value applies in practical terms, we will examine four alternative valuation formulas. Each is well known, and each is used to estimate the perpetuity (terminal value) in a detailed cash flow analysis. The formulas as presented here, however, add one important assumption: The growth rate of operating profits is held constant in each projection. So, in effect, we are working with multiples.

The first two formulas are typical DCF models.1 They are based on the net present value, with a discount rate based on the capital asset pricing model (CAPM):

(11.1)

and

(11.2)

where

E = market value of equity

FCFe = free cash flow to shareholders2

ke = cost of equity = Rf + βe(RM − Rf), where Rf is the risk-free rate, βe is the levered beta, and RM − Rf defines the market equity risk premium

FCF = operating free cash flow3

k = weighted-average cost of capital

g = growth rate

D = debt.

Note that

(11.3)

where kd = i (1 − t), with i the expected yield on corporate debt.

In recent years, EVA-based methods have become analysts’ preferred approach to corporate valuation.4 In spite of its current popularity, EVA is not a new approach because ...