Corporate and Project Finance Modeling

Chapter 23Overview of Issues When Computing Normalized Cash Flow and Terminal Value

When thinking about the most important things that affect valuations in corporate analysis, making appropriate assumptions is front and center. As Chapter 1 discusses, classic and recurring valuation problems arise from the following seven causes:

1. Assuming that firms in industries where entry is relatively easy can indefinitely earn a rate of return substantially higher than their cost of capital
2. Ignoring the effects of looming increases in capacity in an industry where planned capacity additions outpace growth in demand
3. Relying on opinions and analysis of big companies, famous consulting firms, well-respected experts, and others who are not putting their own money into the investment
4. Believing in fancy newfangled valuation analysis that supposedly produces value from factors other than earning a return above the cost of capital
5. Trusting optimistic forecasts of companies that are trying to increase or maintain returns in the face of stiff competition and that hide information by using incomprehensible financial jargon
6. Misjudging shifts in cost structures and demand in an oligopolistic industry that can quickly render existing assets obsolete
7. Not appreciating and using historical data when evaluating forecasts

While avoiding these types of pitfalls from making bad assumptions is the central basis for any valuation along with having good business judgment, there are also some mechanical financial ...