Lessons in Corporate Finance

CHAPTER 16 Valuation Nuances

In the previous two chapters, we valued Sungreen Corporation using the free cash flow to the firm approach. That is, we estimated future cash flows to the firm and discounted them using an average weighted cost of capital (WACC). This chapter will extend the analysis and provide some nuances about valuation.

This chapter is organized around providing more detail about each of the pieces of valuation: the cash flows, the cost of capital, and then the terminal value. For each piece, we will extend the analysis from Chapters 14 and 15. At the end, we will examine alternative valuation techniques (APV and APT) and other topics.

Cash Flow Nuances

It is important to remember when doing valuations that cash is king. It is cash flows, not earnings, that makes or breaks a firm. A firm can survive for a time with negative earnings but doesn’t last long after experiencing negative cash flows. Remember the quote from the first chapter: “Cash is like air, profits are like food, you need both to survive, but you die much quicker without air.”

For example, start-ups (like the dot-coms) worry mostly about something called the burn rate. That is, how fast a firm “burns” its cash. Many never have positive earnings, but their survival time is actually all about how long the cash will last.

This is not to say earnings don’t matter; earnings matter because they are usually a large part of a firm’s cash flow. But we don’t value a firm merely on earnings, and it is ...