Lessons in Corporate Finance, 2nd Edition

CHAPTER 17Valuation 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: cash flows, cost of capital, and terminal value. For each piece, we will extend the analysis from Chapters 15 and 16. At the end, we will examine alternative valuation techniques (APV and APT) as well as other topics.

CASH FLOW NUANCES

When doing valuations, it is important to remember that cash is king. Cash flows, not earnings, are what make or break 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” (spends) its cash. Many never have positive earnings, but their survival time is actually 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. However, we don't value a firm merely on earnings, and it is ultimately ...