Valuation, 7th Edition

10Frameworks for Valuation

In Part One, we built a conceptual framework to show what drives the creation of value for investors. A company’s value stems from its ability to earn a healthy return on invested capital (ROIC) and its ability to grow. Healthy rates of return and growth produce future cash flows, the ultimate source of value.

Part Two offers a step-by-step guide for analyzing and valuing a company in practice, including technical details for properly measuring and interpreting the drivers of value. Among the many ways to value a company (see Exhibit 10.1 for an overview), we focus particularly on two: enterprise discounted cash flow (DCF) and discounted economic profit. When applied correctly, both valuation methods yield the same results; however, each model has certain benefits in practice. Enterprise DCF remains a favorite of practitioners and academics because it relies on the flow of cash in and out of the company, rather than on accounting-based earnings. For its part, the discounted economic-profit valuation model can be quite insightful because of its close link to economic theory and competitive strategy. Economic profit highlights whether a company is earning its cost of capital and quantifies the amount of value created each year. Given that the two methods yield identical results and have different but complementary benefits, we recommend creating both enterprise DCF and economic-profit models when valuing a company.

Exhibit 10.1  Frameworks for DCF-Based ...