Valuation models based on varying forms of the discounted present value of a firm’s future cash flows are commonly used by analysts and investors seeking to determine a theoretical or target valuation for equity participation in publicly traded firms. These models range from relatively simple present value of discounted cash flow models to complex and sophisticated economic profit and adjusted cash flow models introducing estimated changes in a firm’s value based on opportunity costs and changes in the firm’s capital structure. Most model forms share at least one common theme: the value of a firm, or any asset, is a function of claims firm stakeholders have on the firm’s future cash flows and their interaction with the firm’s expected growth rate (g), Return on Invested Capital (ROIC), and Weighted Average Cost of Capital (WACC), more generally thought of as a discount rate (r).
We’re fortunate to have easily accessible data with respect to the market value of firms’ equity and debt positions, as well as detailed accounting and market data resulting from firm’s efforts. We can motivate the various valuation models, estimate a theoretical value for any particular firm, and then compare that value to the value observed in the open market, reflective of the thinking of buyers and sellers throughout the market. Assuming these buyers and sellers share symmetric information flows such that all agents in a transaction perfectly share and have access to the same data, we might suppose potential buyers and sellers each estimate the same values for firms’ rates of growth, return on invested capital, and costs of capital. Were this the case, why do buyers and sellers assign different values to firms such that a bargaining process is undertaken before a transaction price is agreed upon, if one is agreed upon at all? Additionally, how is it that firm’s may ascribe a value to their operation different from that which the market sets? We might argue this is simply a function of asymmetric or imperfect information between buyers and sellers, and it is, but we would certainly be left to also argue that a firm’s opportunity cost of capital may be different than an investor’s expected return or their opportunity cost of capital.
Among the most important considerations in this exploration involves identifying and utilizing an appropriate expected growth rate for subject firm’s cash flows and observing how differing rates of growth (g) effect the firm’s estimated value. We know the relationship between ROIC and WACC is critical in value creation for the firm: when ROIC > WACC growth adds value to the firm, while growth in the presence of ROIC < WACC destroys value, and when ROIC = WACC growth may be impotent with respect to the firm’s value. Most model calculations include forecasts of firm cash flows during some relatively short explicit forecast period, and then employ an expected long-run growth rate (g) in the continuing value portion of asset valuation model. Given that g reflects the expected growth rate of the firm’s cash flow in perpetuity it has significant impact on the valuation model’s outcome.
It is this Search for g, Return on Invested Capital, and Weighted Average Cost of Capital and the resulting valuations that form the basis for The Valuation Project. Led by Dr. Richard Haskell of Westminster College’s Bill & Vieve Gore School of Business, undergraduate students participating in the project examine publicly available data for the study’s subject firms, present these data as primary or derived variables used in the subject valuation models, motivate the models based on varying levels of g, and then comment on model strength, weaknesses, accuracy, reliability and alternatives.
In the Western conceptualization of the role of firms in society we generally accept that a firm’s stakeholders, those with claims on the firm’s cash flows, include those who have financed the firm through equity and debt investments1. Equity participants have claims on the firm’s cash flows including the profits, some of which are distributed in the form of dividends and the remainder of which are reinvested in the firm through its retained earnings, and accept the risk of firm pricing, production, and distribution decisions, varying dividend levels, and share valuations. Debt holder claims supersede those of equity investors as debt investors enjoy claims on the firm’s cash flow as observed through its net margins from which interest payments and debt retirement funds, often referred to as sinking funds, arise. Together, the market value of a firm’s equity and debt form the firm’s enterprise value, which value rises and falls based on firm performance, market forces, investor’s rational expectations, and what John Maynard Keynes referred to as animal spirits – the sometimes less than rational expectations of firm stakeholders arising from the vagaries of the human condition.
Project Design and Structure
This project explores the value of firms in the DOW Industrials and S&P 100 by assigning values to each firm based on each of five discounted present value models: income augmented dividend growth or discounted dividend model, key value driver model, free cash flow model, adjusted present value model, and economic profit model. The cash flows used in these models, Net Operating Profit Less Adjusted Taxes (NOPLAT), Free Cash Flow (FCF), Tax Shield (TS) and Economic Profit (Eπ)2, each share common inputs, but each measure somewhat different change effects for their respective firms. Each model employs forms of firm growth rate, return on invested capital, and cost of capital or discount rate values, but also bring in other measurable variables from the firm’s income statement and balance sheet.
This study seeks to isolate the firm’s core operating assets, explore expected rates of growth for the subject firm’s revenues and expenses, and estimate future returns and costs of capital in an effort to assign value to the firm. The analysis compares these assigned values with actual market values, estimate hypothetical discount rate values reflected in these market values, and perform multi-linear regression analyses to estimate which model forms most consistently assign values aligned with adjusted market values. Through the study hypotheses will be developed with respect to those motivating principles behind observed differences, which hypotheses and theories will be available to investors, academics, and others through this web site, critically developed academic articles, and a series of Wikipedia pages devoted to the subject and process through which the analysis was performed.
1 The European conceptualization of firm stakeholders includes equity and debt investors, customers, workers, management, suppliers, governments, and the broader society in which the firm operates.
2 Economic profit is generally considered to be the profit a firm derives in excess of the investor’s reasonably expected return on their invested capital the time they put into the management of the firm, for which they are not paid. It is an opportunity cost. In this study, Economic Profit is specifically defined as IC x (ROIC – WACC).