Linking Business Activity to Intrinsic Value: The ModelWare Profitability Tree

As discussed earlier, to determine an intrinsic value of a company we need to understand how it operates and funds its activities, in its “cycle of life”. We illustrated how this is partially reflected in reported financial statements, and how these can be rearranged to better align with the economic activity (Figures A2.1 through A2.4). We then developed the basic conceptual approach to valuation, showing how DDM, DCF and RIV are conceptually consistent, but practically RIV has distinct advantages. One of the primary advantages is that the inputs to the valuation calculation are the elements of the business and the financial reporting system that are observable and serve as the starting point in forecasting future performance of a business. This basic linkage is the “Profitability Tree” shown in Figure 17.1.

For a variety of reasons, including the way people are taught, and because analysts have become so focused on forecasting a company's quarterly (reported) earnings, we see forecast models built on standard financial reporting formats, with a strong focus on revenue growth, followed by working through each element in the financials. The left-hand side of the basic Profitability Tree shows how the balance sheet and income statement, reclassified to separate operating and financing elements, flow into the ROE measure used in RIV or the operating and financing valuations in equations (16) and (17) ...

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