In a market-driven economy investors are looking for the most profitable placement of their capital. This leads to a redistribution of the recourses on economy-wide scale from industries and companies which use investor’s capital inefficiently and destroy wealth to industries and companies which use investor’s capital efficiently and create wealth. For corporate managers, wealth creation is fundamental to the economic survival of the firm. As suggested by Rapport (2006, pp.67-68) managers that fail (or refuse) to see the importance of this imperative in an open economy do so at the peril of the organization and their own careers. There are several analytical tools which can help to make wise decisions in this field. They range from traditional Dividend Discount model and Free Cash Flow (FCF) model to not so long ago created Economic Value Added (EVA) model of enterprise valuation.
At the same time in line with theoretical models for valuing companies there is a market value for companies derived from market supply and demand for their stocks. In general, if we again refer to “one value principle” described in Grant (2003, p.106), both theoretical and market approaches have to lead to the same results. But in reality there is always some discrepancy in those two values which is a result of the influence of the number of factors. Identification and analysis of those factors is of key importance for investors to discover the most profitable investments and for the economy to ensure the most efficient use of capital.
The discrepancy between theoretical and market value of the company, however, should not last forever. If it happens then capital market will be sending wrong signals to the investors about on the one hand industries with high potential which use capital productively and create economic profit and on the other hand industries with low potential who waste capital and achieve economic loss. This would lead to a situation when productive industries will face a deficit of capital and unproductive industries will face a surplus of capital. Such inefficient distribution of capital finally would be a threat for the development of a real sector of the economy.
Table of Contents
1. Introduction
2. Theory of enterprise valuation model
2.1. FCF valuation model
2.2. EVA valuation model
2.3. Comparison of FCF and EVA models
3. Problems in Enterprise valuation
3.1. Ex ante MVA and Ex post MVA
3.2. Calculation of WACC
4. Conclusion
Objectives and Topics
The paper aims to evaluate and compare traditional Free Cash Flow (FCF) valuation models with the Economic Value Added (EVA) approach, focusing on their theoretical consistency and practical application in corporate finance.
- Theoretical foundations of FCF and EVA valuation models.
- Comparative analysis of enterprise value calculation methods.
- Evaluation of market inefficiencies and their impact on MVA.
- Challenges associated with the calculation of the Weighted Average Cost of Capital (WACC).
Excerpt from the book
2.1. FCF valuation model
As described in Grant (2003, p.107) according to financial theory, the market value of any company can be expressed as a discounted stream of future cash flows. In formal terms, we can express the enterprise value of the firm as: EV = Σ T=1 to ∞ FCF_T / (1+c*)^T (1).
In this expression, EV denotes enterprise value, FCF_T is the firm’s estimated free cash flow (FCF) at period T (which represent final year of life for analyzed investment), and c* is the discount rate or firms cost of capital which is measured as a adjusted for taxes weighted average cost of capital (WACC). Detailed calculation of WACC and problems associated with it will be discussed later.
In turn, the firm’s assessed FCF at year T can be viewed as the anticipated net operating profit after tax, NOPAT, less the annual net investment, IN, to support the firm’s growth. In formal terms, we have: FCF_T = NOPAT_T - IN_T (2).
Before proceeding, it should be noted that we can make a distinction between gross investment, IG, and net investment, IN. Specifically, gross investment refers to: (1) capital spending required to maintain the economic productivity of the firm’s existing assets; (2) working capital additions to support a growing revenue and earnings stream; and (3) any new investments made by the firm’s managers in—hopefully—positive NPV projects. On the other hand, net investment, IN, refers to gross investment less (in principle) economic depreciation. Summarizing these results, in the traditional free cash flow model, the firm’s enterprise value is equal to the present value of its expected free cash flow stream, where the expected free cash flow at period t can be expressed as NOPAT less the corresponding net investment.
Summary of Chapters
1. Introduction: Outlines the importance of enterprise valuation for capital allocation and introduces FCF and EVA as primary analytical tools.
2. Theory of enterprise valuation model: Details the mathematical foundations of the FCF and EVA models and compares their utility in assessing firm value.
3. Problems in Enterprise valuation: Discusses the challenges of market inefficiency, forecasting inaccuracies, and complexities in calculating WACC.
4. Conclusion: Synthesizes the findings, noting that while both models yield consistent results, EVA offers superior insights into periodic wealth creation.
Keywords
Enterprise Valuation, Free Cash Flow, FCF, Economic Value Added, EVA, Market Value Added, MVA, WACC, Capital Structure, Wealth Creation, Corporate Finance, Investment Analysis, NOPAT, Discounted Cash Flow, Cost of Capital.
Frequently Asked Questions
What is the primary focus of this paper?
The paper examines the theoretical framework and practical application of enterprise valuation models, specifically comparing the Free Cash Flow (FCF) and Economic Value Added (EVA) methods.
What are the central thematic areas?
The work covers valuation theory, the calculation of enterprise and equity value, the impact of market imperfections on valuation metrics, and the technical difficulties in determining the cost of capital.
What is the primary research goal?
The objective is to demonstrate that while FCF and EVA models theoretically yield identical results, they offer different perspectives on periodic wealth creation and management performance.
Which scientific method is utilized?
The author uses a comparative analysis method, evaluating mathematical formulas and theoretical assumptions from established financial literature alongside a numerical case study.
What topics are covered in the main section?
The main section details the FCF model, the foundations of the EVA model, a comparative numerical example (the ABC company), and critical discussions on market efficiency and WACC estimation.
Which keywords characterize the work?
Key terms include Enterprise Valuation, EVA, FCF, MVA, WACC, and Wealth Creation.
How does the EVA model differ from the FCF model regarding residual value?
The EVA model allows for a more direct calculation by using an explicit expression of Net Present Value (NPV) created by invested capital, which simplifies the residual period calculation compared to the growth-based FCF approach.
What is the "circularity problem" mentioned in the context of WACC?
It refers to the difficulty of determining the cost of equity, as the calculation requires knowing the value of equity, which in turn depends on the discount rate derived from the cost of equity.
How do market inefficiencies influence MVA?
In inefficient markets, the discrepancy between ex ante MVA (theoretical) and ex post MVA (market-based) suggests that shareholder wealth can fluctuate due to factors beyond the firm's operational performance, making periodic EVA less relevant for certain investors.
- Quote paper
- Alina Ignatiuk (Author), 2008, The Enterprise Valuation Theory and Practice, Munich, GRIN Verlag, https://www.grin.com/document/130200
