44 The Financial Times Guide to Corporate Valuation
In this chapter we gave a theoretical overview of various important valu-
ation concepts, such as equity value vs enterprise value and fundamental
vs relative valuation. We then classified the valuation models according to
these concepts (see Figure 4.3) and whether they are based on cash flow,
returns or operational variables.
The most important and commonly used corporate valuation approaches are:
The discounted dividend model (DDM) equals the equity value to
the value of all future dividends discounted back to today using an
appropriate cost of capital.
The discounted cash flow (DCF) model equals the enterprise value
to all future free cash flows discounted back to today using the appro-
priate cost of capital (usually the weighted average cost of capital
The cash flow return on investment (CFROI) model: in contrast to
the DCF, a return ratio is calculated that expresses the company’s cur-
rent or future ability to produce free cash flow. CFROI can be defined
as the sustainable cash flow a business generates in a given year as a
percentage of the cash invested in the company’s assets.
Real options valuation: where the basics of theoretical financial
options pricing are used to price investment opportunities and ulti-
mately companies. It is generally most applicable to companies
whose value is strongly correlated to the success or failure of a cer-
tain opportunity. Examples of industries where real options valuation
might be beneficial include energy (particularly oil and gas) and all
R&D-intensive industries such as biotechnology, pharmaceutical and
The residual income model gives a value of the company based on
the book value of the company plus the discounted value of all future
excess returns after cost of debt and cost of equity have been deducted.
The economic value added (EVA) approach: the enterprise value is
equal to the current capital stock plus the present value of all future
EVA, discounted back to today. EVA for a given year is the excess
return the company enjoys, once all operating as well as capital costs
are covered, and it is calculated as the difference between the return
on capital and the cost of capital, multiplied by the capital stock at the
beginning of the year.