What do we know for sure about ďŹ nancial valuation

?

1

Future Cash Flows

The financial value of any venture can only come from the cash generated in the futureâ€”no accrued values, no actual or historical performance.

âœ˜ Now

12

TimeofValue Money

The longer we have to wait for an amount of money the less it is worth right nowâ€” that's why future cash flows are discounted.

Now

3

12

Risk-Free

Rate of Return

For every major currency there is an interest rate at which we can invest our money, for any horizon, with practically zero riskâ€”the government bond yield curve. Every investment must be compared to this risk-free rate.

Now

%

34

12

Importance of

Risk

The more uncertain a cash flow is the less it is worth. If we buy a bunch of uncertain cash flows which provide us—on average—the same return as a risk-free government bond, we would probably go for the bond—or pay less for those cash flows.

Now

45

23

Valuation of

Uncertainty

What Black and Scholes or Cox, Ross, and Rubinstein developed for special cases in the financial world, we can nowâ€”with Monte Carlo simulationâ€”ulitize for the valuation of every kind of uncertainty.

Probability of Under-Performance

Expected Value

Value of Uncertainty

OK, letâ€˜s see again what we have ...

Future Cash Flows

Future Cash Flows

âŒ›

Time Value of Money

Future Cash Flows

âŒ› %

Time Value of Money Risk-Free Rate of Return

Future Cash Flows

âŒ› %

!

Time Value of Money Risk-Free Rate of Return Importance of Risk

Future Cash Flows

âŒ› %

!

Time Value of Money Risk-Free Rate of Return Importance of Risk Valuation of Uncertainty

5

So, these are the

Five truths

we know about ďŹ nancial valuation

Future Cash Flows

âŒ› %

!

Time Value of Money Risk-Free Rate of Return Importance of Risk Valuation of Uncertainty

And what donâ€˜t we know? Or what are the

? Lies

And what donâ€˜t we know? Or what are the

? Lies

(Even if we pretent they were true?)

Rock-Solid Future Cash Flows

Although everybody knows that future cash flows are highly uncertain, almost all financial projections, planning, budgets, etc. treat them exactly like thisâ€”rocksolid figures.

Now

âœ˜

Lie!

So, it's a

Now

✘

Equity Cost of

Capital 9.

95 %

The cost of capital is a fiction: A crucial part of capitalâ€”equityâ€”has no price tag. Although the WACC* is critical to valuation, there is little practical guidance on how to determin it. The cost of capital is no ingredient to the valuation rather than one of its possible results.

WACC = Cost of Debt +

Cost of Equity

?

? ? ?

Market Risk Premium

CAPM

5% .7 7

*) Weighted Average Cost of Capital

MCPMTM

Beta

Stock Price Volatility

Lie!

Capital Cost is a

WACC = Cost of Debt +

Cost of Equity

?

? ? ?

Market Risk Premium

CAPM

5% .7 7

*) Weighted Average Cost of Capital

MCPMTM

Beta

Stock Price Volatility

What We Know About Valuation

Published on Jan 22, 2010

This presentation is about what we really know about financial valuation--and what's just myth.

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