Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

A SIMPLE FINITE-GROWTH MODEL

The new model is developed here for two cases—a firm that does not pay a dividend and reinvests all of its earnings in new positive-NPV projects and a firm using a reinvestment rate that is either higher or lower than 100 percent of its earnings.

Case 1: All Earnings Reinvested in Positive-NPV Projects

Assume that a firm does not currently pay a dividend and will not pay a dividend until t = τ + 1. The firm’s existing assets will produce a perpetual (after-tax) cash flow stream per share in the amount Et = 1. The first cash flow will be received in one year, at t = 1. This cash flow is calculated as follows: Accounting earnings are increased by the amount of any noncash charges, such as depreciation. At the same time, accounting earnings are reduced by the investment necessary to maintain the level of cash flow. Accounting earnings may need to be further adjusted if the estimated earnings for t = 1 are unusually high or low because of the cyclical nature of the business or because of nonrecurring accounting adjustments.

The firm has a competitive advantage that will allow it to invest its entire earnings in positive-NPV projects during each of the next τ years. These projects offer a return on equity, RN, that is greater than the risk-adjusted required return on equity, k. Each dollar of equity investment will generate a perpetual annual cash flow in the amount RN starting at the end of the year following the investment. The model assumes that the inflation ...