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 future—no accrued values, no actual or historical performance.
✘ Now
12
TimeofValue Money
The longer we have to wait for an amount of money the less it is worth right now— 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 risk—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 now—with Monte Carlo simulation—ulitize for the valuation of every kind of uncertainty.
Probability of Under-Performance
Expected Value
Value of Uncertainty
OK, let‘s see again what we have ...
Future Cash Flows
Future Cash Flows
⌛
Time Value of Money
Future Cash Flows
⌛ %
Time Value of Money Risk-Free Rate of Return
Future Cash Flows
⌛ %
!
Time Value of Money Risk-Free Rate of Return Importance of Risk
Future Cash Flows
⌛ %
!
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
⌛ %
!
Time Value of Money Risk-Free Rate of Return Importance of Risk Valuation of Uncertainty
And what don‘t we know? Or what are the
? Lies
And what don‘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 this—rocksolid figures.
Now
✘
Lie!
So, it's a
Now
✘
Equity Cost of
Capital 9.
95 %
The cost of capital is a fiction: A crucial part of capital—equity—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