Frameworks for Valuation

In Part One, we described an overall framework for understanding what drives value and how managers can use these concepts to create value in their companies. In particular, we made the case that a company's value is driven by its ability to generate cash flow over the long term. Furthermore, a company's cash-flow generating ability (and hence its value creation ability) is driven by long-term growth and the returns that the company earns on invested capital relative to its cost of capital.

Part Two provides a step-by-step guide to analyzing and valuing a company, including technical details on how to get the numbers right and guidelines for interpreting the results. The first chapter of Part Two provides a high-level summary of how to value a company using the discounted cash flow approach and describes some of the alternatives to this method. Chapters 9 to 13 detail each step in the valuation process.

While there are a number of ways to apply the discounted cash flow (DCF) approach, over the next five chapters we will describe two in detail: the enterprise DCF model and the economic profit model. The enterprise DCF model is the most widely used in practice. The economic profit model is gaining in popularity. Its advantage is that it highlights whether a company is earning its cost of capital. It is important to point out that both models result in exactly the same value, so the choice is mostly driven by the instincts of the user. At the end of this chapter, we discuss two other models: the adjusted present value (APV) model and the equity DCF model. These models are particularly useful in special situations. For example, the equity DCF model is best suited for financial institutions such as banks and insurance companies. The APV model is helpful for valuing companies with changing capital structures, such as leveraged buyout targets. These two models also give the same result as the enterprise DCF and equity DCF models.

The Enterprise Discounted Cash Flow Model

The enterprise DCF model values the equity of a company as the value of a company's operations (the enterprise value that is available to all investors) less the value of debt and other investor claims that are superior to common equity (such as preferred stock). The values of operations and debt are equal to their respective cash flows discounted at rates that reflect the riskiness of these cash flows. Exhibit 8.1 illustrates this model. As long as the discount rates are selected properly to reflect the riskiness of each cash flow stream, the enterprise approach will result in exactly the same equity value as if we directly discounted the cash flow to the shareholders at the cost of equity.

The enterprise DCF model is especially useful when extended to a multibusiness company, as shown in Exhibit 8.2. The equity value of the company equals the sum of the values of the individual operating units, plus cash-generating corporate assets, less the present value of the cost of operating the corporate center and the value of the company's debt and

Exhibit 8.1 Enterprise Valuation of a Single-Business Company

Exhibit 8.2 Enterprise Valuation of a Multibusiness Company

preferred stock. The exhibit helps highlight the reasons for recommending the enterprise DCF model:

• The model values the components of the business that add up to the enterprise value, instead of just the equity. This helps in identifying and understanding the separate investment and financing sources of value for the equity holders.

• This approach helps pinpoint key leverage areas and therefore aids the search for value-creating ideas.

• It can be applied consistently at different levels of aggregation (i.e., the company as a whole or individual business units) and is consistent with the capital budgeting process most companies are already familiar with.

• It is sophisticated enough to deal with the complexity of most situations, while at the same time easy to carry out with simple personal computer tools. Exhibit 8.3 is a basic valuation summary for the Hershey Foods Corporation.

Exhibit 8.3 Hershey Foods—Free Cash Flow Valuation Summary

Year Free cash



flow (FCF)


value of FCF

(i million;


($ million1)

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