Effective Valuation

By Cote, Jean-Victor | Strategic Finance, July 2007 | Go to article overview

Effective Valuation


Cote, Jean-Victor, Strategic Finance


Future and current managers and investors who want to help their companies create value may be interested in Valuation: Measuring and Managing the Value of Companies by Tim Koller, Marc Goedhart, and David Wessels, which was originally developed as a handbook for McKinsey consultants. In it, the authors provide detailed instructions about valuing companies by following the path traced by generations of fundamental analysts, only improved and updated with insights from the latest financial theories and empirical studies.

The emphasis throughout is on actionable insights and sustainability. The authors debunk some well-entrenched misconceptions about value, especially about price earnings multiples, and provide a wealth of advice about valuation pitfalls. They also explain how to communicate with employees and investors about value, and they consistently provide examples from major industries and companies to illustrate their main recommendations.

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They begin by presenting the argument that "deviations from intrinsic value tend to be short-lived" in the stock market, backing up the claim by drawing from a wealth of data on the stock market and discussing stock market inefficiencies at length.

Next they describe a model of value creation with three parameters: growth, the return on invested capital (ROIC), and the weighted average cost of capital (WACC). Those parameters can be integrated into at least three well-known valuation models--the discounted cash flow (DCF) model, the economic profit model, and the adjusted present value (APV) model. The authors demonstrate the equivalence between these models and how their parameterization streamlines the forecasting process. For example, the equivalence relation between the DCF and economic profit models provides opportunities to double-check calculations. In particular, the parameterization helps provide reasonable first approximations.

The model is integrated into a conceptual framework for value creation that is analogous to the product life cycle model in marketing. It provides contextual managerial guidelines for each stage of value creation. Linking financial forecasts to economic forecasts is an essential feature of this model (especially the economic profit version of it), as is linking financial drivers of value to operational drivers of performance. The first linkage is to strategy, and the second is to tactics. The discussions about strategy are grounded in managerial economics and include considerations, for instance, about signaling effects and information asymmetry.

Most of the valuation worksheets the authors include have built-in double checks, such as reconciliations between net income and net operating profit less adjusted taxes, free cash flow and cash flow available to investors, and so forth. …

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