Equity Valuation and Portfolio Management

BACKGROUND

At the heart of the FFM is the separation of firm value into two distinct parts: tangible value (TV) and franchise value (FV). Each of these value components separately contributes to the P/E. TV can be reasonably estimated because it reflects current businesses that produce steady earnings streams. From a valuation perspective, the TV makes a more predictable contribution to the firm's price-to-earnings ratio (P/E) than does the FV. The P/E contribution, P/E_TV, will be somewhat sensitive to inflation, to interest rates and to the equity market risk premium. Since these factors typically change more slowly than estimates of future opportunities, P/E_TV is relatively stable.

The total P/E is the sum of P/E_TV and P/E_FV. FV is dramatically different than TV and much more difficult to estimate accurately. This difficulty is related to the futuristic nature of FV. FV reflects businesses that a firm is expected to create at some (possibly indeterminate) point in the future by means of new, yet to be realized, investments. As investors, market analysts and corporate executives polish their crystal balls and peer into the future, their projections of a firm's growth opportunities will continually change along with estimates of FV.

Because of their prospective nature, FV estimates are more vulnerable to sudden changes in markets and in the global economy than TV estimates. Such changes can work in either a positive or negative direction. Long-term projections can just as easily ...