202  Frameworks for Valuation One situation where the equity cash flow model leads to the simplest implementation is the analysis and valuation of financial institutions. Since capital structure is a critical part of operations in a financial institution, using enterprise DCF to separate operations and capital structure requires unneces- sary assumptions. This is why Chapter 38 uses the cash-flow-to-equity model to value banks and other financial institutions. Problematic Modifications to Discounted Cash Flow In this chapter, we valued GlobalCo by discounting nominal cash flows at a nominal cost of capital. An alternative is to value companies by projecting cash flow in real terms, ignoring the rise in prices, and discounting this cash flow at a real discount rate (the nominal rate less expected inflation). But most manag- ers think in terms of nominal rather than real measures, so nominal measures are often easier to communicate. In addition, interest rates are generally quoted nominally rather than in real terms, excluding expected inflation. A second difficulty occurs when calculating and interpreting ROIC. The historical statements are nominal, so historical returns on invested capital are nominal. But if the projections for the company use real rather than nomi- nal forecasts, returns on new capital are also real. Projected returns on total capital—new and old—are a combination of nominal and real, so they are impossible to interpret. The only way around this is to restate historical per- formance on a real basis, which is a complex and time-consuming task. The extra insights gained rarely equal the effort, except in extremely high-inflation environments, described in Chapter 26. A second alternative to the enterprise DCF method outlined earlier is to discount pretax cash flows at a pretax hurdle rate (the market-based cost of capital multiplied by 1 plus the marginal tax rate) to determine a pretax value. This method, however, leads to three fundamental inconsistencies. First, the government calculates taxes on profits after depreciation, not on cash flow after capital expenditures. By discounting pretax cash flow at the pretax cost of capital, you implicitly assume capital investments are tax deductible when made, not as they are depreciated. Furthermore, working- capital investments, such as accounts receivable and inventory, are never tax deductible. Selling a product at a profit, rather than holding inventory, is what leads to incremental taxes. By discounting pretax cash flow at the pretax cost of capital, you incorrectly assume that investments in operat- ing working capital are tax deductible. Finally, it can be shown that even when net investment equals depreciation, the result will be downward bi- ased—and the larger the cost of capital, the larger the bias. This bias occurs because the method is only an approximation, not a formal mathematical relationship. Because of these inconsistencies, we recommend against dis- counting pretax cash flows at a pretax hurdle rate. Alternatives to Discounted Cash Flow  203 Alternatives to Discounted Cash Flow To this point, we’ve focused solely on discounted cash flow models. Two addi- tional valuation techniques are using the multiples of comparable companies and real options. Multiples One simple way that investors and executives value companies is to value a company in relation to the value of other companies, akin to the way a real estate agent values a house by comparing it with similar houses that have recently sold. To do this, first calculate how similar companies are valued as a multiple of a relevant metric, such as earnings, invested capital, or an operat- ing metric like barrels of oil reserves. You can then apply that multiple to the company you are valuing. For example, assume the company’s NOPAT equals $100 million and the typical enterprise-value-to-NOPAT multiple for compa- nies in the industry with similar growth and ROIC prospects is 13 times. Mul- tiplying 13 by $100 million leads to an estimated value of $1.3 billion. Multiples can be a great check on your DCF valuation if done properly. Suppose the value estimated by multiples is $1.3 billion, but your DCF value is $2.7 billion. This might be a clue that there is something wrong with your DCF valuation model. Alternatively, it could be that the company you are valuing is expected to perform differently than the comparable companies. Finally, it could be that investors have a different outlook for the entire indus- try than you do (in which case the multiples of all the comparable companies would be out of line with their DCF value). Of course, it could just be that your multiples valuation wasn’t performed properly. Because of their broad use and potential for error, we devote Chapter 18 to valuation using multiples. In a nutshell, to use multiples properly, you need to carefully choose the mul- tiple and the comparable companies. In the case of earnings multiples, we rec- ommend using ratios of enterprise value to NOPAT rather than price to earnings or enterprise value to earnings before interest, taxes, depreciation, and amortiza- tion (EBITDA). We also urge you to be careful when choosing the comparable companies. The comparable companies not only should be in the same industry, but also should have similar performance, as measured by ROIC and growth. Real Options and Replicating Portfolios In 1997, Robert Merton and Myron Scholes won the Nobel Prize in econom- ics for developing an ingenious method to value derivatives that avoids the need to estimate either cash flows or the cost of capital.18 Their model relies 18 Fischer Black would have been named as a third recipient, but the Nobel Prize is not awarded posthumously.