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Appendix Discussions

28.1 EGQ'S MUTED SENSITIVITY TO ASSUMED WACC

Provided the initial cost of capital assumption is a reasonable estimate (we base it on CAPM), EGQ will very reliably measure a company's value-added growth potential relative to its EBV without distortions caused by an incorrect cost of capital assumption. This allows investors to compare the worth of a company's expected value-added growth potential (relative to the value of its existing earnings) to that of peer companies without distortions from minor inaccuracies in the assumed cost of capital. This allows EGQ regressions to identify the market's assigned cost of capital for a group of peer companies independent of the cost of capital assumptions made in the DCF to calculate company EGQs.

Consider a firm with yearly NOPAT from existing business of $100 and incremental opportunities as shown in Figure 28.1.

image

Figure 28.1 EGQ is less sensitive to changes in WACC than most valuation models

Figure 28.1 demonstrates important aspects of EGQ related to the assumed cost of capital.

  • (1) Given a decrease in WACC, the DCF-based enterprise value will increase, but so will both the present value of existing business (EBV) and the present value of incremental opportunities (IVC).
  • (2) Accordingly, EGQ is far less sensitive to changes in the cost of capital assumption than a traditional DCF-based share or enterprise value ...

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