Equity Valuation: Models from Leading Investment Banks

15

Linking Fundamental Analysis to the Inputs of the Valuation Model

To measure intrinsic value we start by estimating the cash that can be taken out of a business during its remaining life. To illustrate our approach, we follow a logical process, starting with a new business.

At the inception of a business, a company gets funding from the owners (shareholders) and often from other lenders who give them fixed terms of repayment, hence becoming obligations or debt of the corporation. Managers of the business use this (cash) funding to purchase or hire resources (e.g. equipment, goods and services), take actions to transform the resources and then resell the “new” products or services to customers, usually at a higher price. The customers (hopefully) pay the company for their purchases, and this cash is usually first used to service the company's obligations, before it goes to the owners.

Over time, the managers have to decide how to use any excess or “free” cash. They could return the cash to the owners, in which case we no longer have to consider its future use. But if they choose to retain the cash, then we have to consider how it is going to be used in the future. The first question is what do the managers need to spend to sustain the current level of business, and what is the source of funding for this. Then we ask what else they need or will spend to generate growth in the business, and how profitably they can do this. If there is demand for the company's products or innovations, ...