177 10 Frameworks for Valuation In Part One, we built a conceptual framework to show what drives the creation of value for investors. A company’s value stems from its ability to earn a healthy return on invested capital (ROIC) and its ability to grow. Healthy rates of return and growth produce future cash flows, the ultimate source of value. Part Two offers a step-by-step guide for analyzing and valuing a com- pany in practice, including technical details for properly measuring and interpreting the drivers of value. Among the many ways to value a com- pany (see Exhibit 10.1 for an overview), we focus particularly on two: en- terprise discounted cash flow (DCF) and discounted economic profit. When applied correctly, both valuation methods yield the same results; however, each model has certain benefits in practice. Enterprise DCF remains a fa- vorite of practitioners and academics because it relies on the flow of cash in and out of the company, rather than on accounting-based earnings. For its part, the discounted economic-profit valuation model can be quite in- sightful because of its close link to economic theory and competitive strat- egy. Economic profit highlights whether a company is earning its cost of capital and quantifies the amount of value created each year. Given that the two methods yield identical results and have different but complementary benefits, we recommend creating both enterprise DCF and economic-profit models when valuing a company. Both the enterprise DCF and economic-profit models rely on the weighted average cost of capital (WACC). WACC-based models work best when a com- pany maintains a relatively stable debt-to-value ratio. If a company’s debt-to- value ratio is expected to change, WACC-based models can still yield accurate results but are more difficult to implement correctly. In such cases, we recom- mend an alternative to WACC-based models: adjusted present value (APV). APV discounts the same free cash flows as the enterprise DCF model but uses the unlevered cost of equity as the discount rate (without the tax benefit of debt). 178  Frameworks for Valuation It then values the tax benefits associated with debt and adds them to the all- equity value to determine the total enterprise value.1 When applied properly, the APV model results in the same value as the enterprise DCF value. This chapter also includes a brief discussion of capital cash flow and equity cash flow valuation models. Properly implemented, these models will yield the same results as enterprise DCF. However, given that they mix operating performance and capital structure in cash flow, we believe implementation er- rors occur more easily. For this reason, we avoid capital cash flow and equity cash flow valuation models, except when valuing banks and other financial institutions, where capital structure is an inextricable part of operations (for how to value banks, see Chapter 38). Enterprise Discounted Cash Flow Model The enterprise DCF model discounts free cash flow (FCF), meaning the cash flow available to all investors—equity holders, debt holders, and any other in- vestors—at the weighted average cost of capital, meaning the blended cost of capital for all investor capital. The company’s debt and other nonequity claims on cash flow are subtracted from enterprise value to determine equity value.2 Equity valuation models, in contrast, value directly the equity holders’ cash flows. Exhibit 10.2 demonstrates the relationship between enterprise value and equity value. For this example, it is possible to calculate equity holders’ 2 Throughout this chapter, we refer to debt and other nonequity claims. Other nonequity claims arise when stakeholders other than shareholders have a claim against the company’s future cash flow but do not hold traditional interest-bearing debt or common stock. Nonequity claims include debt equivalents (e.g., operating leases and unfunded pension liabilities) and hybrid securities (e.g., convertible debt and employee options). 1 Leveraged buyouts conducted by private-equity companies often use substantial leverage to finance the acquisition. In these situations, discount free cash flow at the unlevered cost of equity and evaluate the benefits of financial structure separately. EXHIBIT 10.1  Frameworks for DCF-Based Valuation Model Measure Discount factor Assessment Enterprise discounted cash flow Free cash flow Weighted average cost of capital Works best for projects, business units, and companies that manage their capital structure to a target level. Discounted economic profit Economic profit Weighted average cost of capital Explicitly highlights when a company creates value. Adjusted present value Free cash flow Unlevered cost of equity Incorporates changing capital structure more easily than WACC-based models. Capital cash flow Capital cash flow Unlevered cost of equity Combines free cash flow and the interest tax shield in one number, making it difficult to compare operating performance among companies and over time. Equity cash flow Cash flow to equity Levered cost of equity Difficult to implement correctly because capital structure is embedded within the cash flow. Best used when valuing financial institutions.