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Chapter 9. Valuation of Companies > Methods for Discounting Cash Flows and Resi...

Methods for Discounting Cash Flows and Residual Income

Principles

Perhaps the most common valuation technique is the free cash flow method. The starting point is based on forecasting the company's free cash flows available for shareholders or to its entire set of capital providers. These include earnings, adjusted for expenses and income that are not in cash (for example, depreciation), and adjusted for required investments and changes in working capital. The series of forecast free cash flows is then brought to current values by discounting it using the company's cost of equity or overall cost of capital.

A conceptually equivalent method, the residual income method, is based on forecasting the company's excess earnings (essentially, net income after charging for the cost of the capital employed to achieve it). Similar to the free cash flow method, the series of forecasted excess earnings is then brought to current values by discounting it using the company's cost of equity. Here, investors use the intuition that a company is creating wealth only if it provides earnings that more than compensate capital providers for the risks they take. The method, which we can trace back to its origins a century ago, is widely used in academia as well as in business circles and appears, with different flavors, under names such as Economic Value Added (EVA), Super Profits, and Abnormal Earnings.


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