Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

VALUE CREATION

With a traditional discounted cash flow model, the value of a company can be enhanced in four basic ways. First, companies can increase cash flows from existing assets, either by increasing after-tax earnings from assets in place or by reducing the reinvestment necessary to maintain these assets.

Second, companies can increase the expected growth rate, either by increasing the reinvestment rate or, better still, increasing the return on the reinvestments.

The third way to enhance value is to extend the high-growth period. In DCF analysis, excess return (i.e., earning more than the cost of capital) drives growth. For this effect to be true, the company must have some barrier to entry, because in a competitive marketplace, excess return acts as a magnet. So, lengthening the high-growth period requires figuring out a way to increase the barriers to entry.

Fourth, reducing the cost of capital will enhance value. Companies can diminish cost of capital by reducing the operating risk in investments and assets, changing the financial mix, or changing the financing composition.

Ultimately, these four actions are the only ways to create value. The converse of this proposition is that, by definition, an action that does not affect cash flows, the growth rate, the length of the growth period, or the cost of capital cannot affect value.

Value-Neutral Actions

Arguably, 80 percent of what companies do is value neutral. Such activity may generate publicity, but it has no effect ...