The Value Creation Process
This chapter reviews a few core concepts and terms that we will employ extensively later. On purpose, we are not going into an extensive academic treatise on these concepts and terms here.
Cost of capital is the weighted average cost of both debt and equity. Its estimation is controversial. We will explain our methodology for estimating it later. We'll compare methodologies.
Most fundamentally, however, corporate managers use cost of capital to discount future cash flows to the present to calculate the value of a project, the value of a business, or the value of a strategy.
Then, they calculate a return on capital in order to compare the project to the cost of capital. Projects, businesses, or strategies that produce returns above the cost of capital create value for the shareholder. Returns below the cost of capital destroy shareholder value.1 It's that simple (well, almost).
Funny, a large majority of investment techniques on valuation don't even mention the cost of capital or the firm's return on capital. Please take a look at Yahoo Finance on the “Valuation Measures” tab. You'll see market capitalization, enterprise value, trailing P/E, PEG ratio, price/sales, price/book (enterprise value)/revenue, and (enterprise value)/EBITDA. These are simplistic valuation measures, shorthand proxies for the underlying causations. By proxies, we mean simplistic comparable ratios. These ratios are a result ...