Corporate value, the economic value of the business or strategy, consists of:
The cash flows are "discounted" by the firm's "cost of capital," or required rate of return, which takes into account the firm's level of both business and financial risk.
There is a third component, the value of investments in assets not involved in operations (passive investments). Their value can be added as a "plugged" number or separately modeled and added to Corporate value. See (c) below.
In general, then: Corporate Value = Value created during the Forecast Period (discounted cash flows) +Value after the Forecast Period (residual value)
The discounted cash flows (or, more precisely, the "cumulative present value of cash flows") represent the expected net cash inflows to the business, independent of the firm's financing or dividend policies:
Cash Flow from Operations = Actual dollar inflows + Out of Pocket Dollars
In Strategic Finance, after you've determined the cash flow from operations for each year in the forecast period, those flows are discounted back to present-value terms, using a discount factor based on the cost of capital.
Only a small portion of a company's market value can be reasonably attributed to its estimated cash flows during a forecast period of 5 or 10 years. The remaining portion, called the residual value, typically represents well over 50% (and usually closer to 80%) of the total corporate value. There are several different ways to measure this value.
For a precise estimation of corporate value, a third component must also be included - the current market value of investment holdings. Examples include: marketable securities, investments in stocks and bonds, investments in unconsolidated subsidiaries, an overfunded pension plan, and liquid non-operating assets. These items are not accounted for in the cash flows, but they have a value to the firm, so their value must be added to the other two components.
The reason that marketable securities are not included in the working capital requirements used in estimating cash flow is that they represent cash holdings beyond those necessary for operating the business. Note also that debt (specifically, the current portion of long-term debt) is not included. Debt holders and equity holders hold the "claims" to the net cash flows generated by the firm. They are part of the capital structure and to include them in the investment requirements is "double counting". |
To summarize, Corporate value has three components: Cash flows, residual value and investments