You could stop right here and say that once you have projected free cash flow and discounted it at the WACC, the valuation is complete. This would not be satisfying, however, because you have not evaluated the free cash flow projection upon which the valuation was based. How does the projection compare to past performance? How does the projection compare with other companies? What are the economics of the business? Are they expressed in a way that managers and others can understand? What are the important factors that could increase or decrease the value of the company? You need to step back and understand the underlying economic value drivers of the business.
Since value is based on discounted free cash flow, the underlying value drivers of the business must also be the drivers of free cash flow. There are two key drivers of free cash flow and ultimately value: the rate at which the company is growing its revenues, profits, and capital base, and the return on invested capital (relative to the cost of capital). These value drivers make common sense. A company that earns higher profit for every dollar invested in the business will be worth more than a similar company that earns less profit for every dollar of invested capital. Similarly, a faster growing company will be worth more than a slower growing company if they are both earning the same return on invested capital (and this return is high enough to satisfy the investors).
A simple model will demonstrate how growth and return on invested capital actually drive free cash flow. First, some definitions are needed. Return on invested capital (ROIC) equals the operating profits of the company divided by the amount of capital invested in the company.
What Drives Cash Flow and Value
Value of Equity
The value of the company’s equity is the value of its operations plus nonoperating assets, such as investments in unrelated, unconsolidated businesses, less the value of its debt and any nonoperating liabilities. The valuation of Hershey’s equity is $9.4 billion, including $450 million r[...]
Interest Rate Swaps
Interest rate swaps are simply a form of multiple period FRAs. The term of the agreements may be a matter of many months or even years. As is the case with FRAs there is no exchange of principal. The netting effect disguises the true nature of this transaction. The duration of an asset or liability [...]
FINANCIAL FUTURES
Futures represent a contractual agreement to buy or sell a financial instrument or commodity at a fixed price on a fixed future date. Futures differ from forward contracts in that they are traded on an exchange while forwards are contracts between two parties. A crucial difference between an option [...]
INVESTORS AND CURRENCY RISK
The relationship between institutional investors and the idea of currency risk has been an uneasy one. For a start, there remain an overly large number of investors who are either unwilling or unable, due to the specific regulations of their fund, to consider currency risk as separate and independen[...]
THE CORPORATION AND PREDICTING EXCHANGE RATES
A key aspect of corporate pricing strategy is forecasting future exchange rates. Aside from using banks to help them do this, the internal models corporations use are typically one or more of the following kinds: Political event analysis Fundamental Technical For the reasons we have mentioned earli[...]
BUDGET RATES
The setting of budget rates is crucially important for a corporation as it can drive not only the corporation’s hedging but also its pricing strategy as well. Budget exchange rates can be set in several ways. The benchmark or budget rate for an investment in a foreign subsidiary should normally be[...]