Economic Profitability and the Valuation
of the Firm

Abstract

Many discounted cash flow models produce estimates of firm value that are implicitly based upon economically implausible perpetual forecasts of firm profitability. This discrepancy arises because standard free cash flow models leave operating profits and capital levels as free parameters. In this article, the author develops a simple model that explicitly incorporates firms’ steady-state returns on invested capital into the valuation equation, thereby addressing the free-parameter problem. He provides evidence that capital growth rates are historically less volatile than free cash flow growth rates and are more useful for accurately predicting firm value within the small sample sizes typically found in practice. With several empirical tests comparing his presented model to commonly used valuation models, the author demonstrates that together these contributions result in improved accuracy and variability of valuation estimates, leading to a new method of discounted cash flow analysis that is more robust and more accurate than other commonly employed alternatives.

TOPICS: Portfolio construction, statistical methods, equity portfolio management