Business Valuation Methods and Value-Based Management
Valuation and value-based management
This domain covers DCF, dividend valuation, free cash flow, multiples, asset-based valuation, EVA and MVA. The exam tests both the calculation and the logic of matching cash flow to discount rate.
Core rules
- DCF values expected future cash flows at a rate reflecting their risk.
- FCFF is discounted at WACC to give enterprise value; FCFE is discounted at Ke to give equity value.
- Gordon growth: P0 = D1/(Ke - g) or TV = FCFn+1/(WACC - g).
- Multiples are relative valuation: P/E, EV/EBITDA, P/B; use comparable companies and adjust for growth and risk.
- EVA = NOPAT - (WACC times invested capital); MVA = market value - invested capital.
Worked example
A company has NOPAT of LKR 12m, invested capital LKR 80m and WACC 10%. EVA = 12m - (0.10 times 80m) = LKR 4m. If its market value is LKR 100m, MVA = LKR 20m. A positive EVA means the company earned more than its cost of capital. If NOPAT were LKR 7m, EVA would be -LKR 1m even though accounting profit was positive; the company would be destroying value.
Traps
Do not discount FCFF at Ke or FCFE at WACC; do not use a growth rate above WACC in perpetuity; do not apply a P/E multiple without checking accounting policies and growth; and do not treat asset book value as market value.