Corporate and Project Finance Modeling

Chapter 33Errors and Distortions in Applying the Value Driver Formula

A formula referred to in this chapter as the value driver formula explicitly considers both the growth rate and the prospective return in establishing value. This formula, (1 − Growth/Return)/(Cost of Capital − Growth), can seemingly simulate alternative assumptions with respect to convergence in returns and cost of capital over the long term. The formula is popular with some technicians for computing terminal value and with some university professors. As the value driver formula considers all three value drivers—returns, risks, and growth—it seems to solve problems inherent with both the stable growth rate method and the application of valuation multiples. Further, as the formula is applied to operating income rather than cash flow, it seems to avoid the need for evaluating normalized working capital, capital expenditures, and deferred taxes. The biggest difference between the stable growth method discussed in the last couple of chapters and the value driver formula discussed in this chapter is that you can directly make an assumption with respect to the rate of return relative to the cost of capital. The growth rate formula FCFF/(WACC − g) used in Chapters 30, 31, and 32 implicitly assumes that the return on investment that exists in the terminal period will be approximately the same indefinitely. Note that the return in the growth formula does not stay precisely the same as the return in the terminal period ...