Firm Valuation Overview

Study Notes

Firm valuation reveals key factors driving a company's success, providing insights into its growth potential and profitability.
Key factors driving firm valuation are growth, return on capital, and cost of capital.
Companies should consider the interests of all stakeholders, not just shareholders, in their decision-making processes.
Long-term value creation requires considering social, environmental, and ethical implications of business activities.
Many managers and investors prioritize short-term financial metrics, such as earnings per share (EPS), over long-term value creation.
Short-term focus can lead to damaging decisions that harm long-term prospects, such as cutting essential investments.
EPS as a performance measure may not reflect the true value created by a company.
Share price and EPS do not always align with intrinsic value.

Firm valuation aims to determine the fair value of a company's assets, operations, and future cash flows.
This valuation is essential for various purposes, including:
- Investment Decision Making
- Mergers and Acquisitions
- Financial Reporting
- Fundraising and Capital Allocation
- Litigation and Dispute Resolution

Companies create value when they earn a return on invested capital (ROIC) greater than their opportunity cost of capital.
Growth may not create value if the ROIC is at or below the cost of capital.
ROIC = after-tax operating profit divided by invested capital (working capital plus fixed assets).
Growth = the rate of increase in a company's revenue, earnings, or market share over a specific period.

The focus shifts from creating value through operations to managing investor perceptions and expectations.
Goal: actual performance exceeding investors’ anticipation impacts share price.
Intrinsic Value = based on future expected cash flows or earnings.
Share Price = influenced by investors' expectations of future performance relative to the company's performance.

A commonly used measure for evaluating company performance and management is total shareholder returns (TSR).
TSR = percent change in market value + dividend yield.
TSR is heavily influenced by changes in investors' expectations.
Expectation Treadmill: High expectations continuously pressure for exceptional performance.
Companies with low expectations may outperform the stock market due to easier targets to surpass.
The Decision Rule in the Real Market: Choose strategies or make operational decisions that maximize the present value of future cash flow.