To: Jacques Newey who wrote (47542 ) 2/10/1998 3:30:00 PM From: Reginald Middleton Read Replies (1) | Respond to
This can be a complex subject, so I will try and take it in parts. Discounted cash flow and economic value added, or EVA, as coined by Stern Stewart, are essentially the same valuation mechanism. The primary difference is that DCF does not accurately account for the full timing AND risk of cash flows. For instance, if a manufacturing company makes 10 dollars per year for 5 years and a biotech company makes 41 dollars in the fifth year, DCF may value them the same given the appropriate discuount rates. Economic profit applies a capital charge, which is the amount invested by the corporation multiplied by the WACC (weigheted average cost of capital). This charge is applied on a year by year basis, so may actually differentiate the two companies in question. The problem with EVA, and general economci profit, is it tends to be very harsh on companies with few tangible assets (ex. mining companies) and companies that invest very heavily under certain conditions. The pro of EVA style valuation is the method it uses to reconcile net income, thereby stripping it of all of it GAAP style accrual accounting inefficiencies. If you have seen any of my other serious posts, you may have noticed that I claim EARNINGS DON'T MEAN ANYTHING! They are tools for accountants, not investors. Investors need only be concerned with cash (this is a dated, informal piece so be lenient - see rcmfinancial.com ).rcmfinancial.com , if you are using NSCP, you will have to use the hyperlinks instead) and business risk analyis. These are the tools that are used to produce the discounting rate. Due to the fact that I have incorporate nearly all of the best parts of economic profit analysis into my DCF analysis, DCF is what I would recommend you go with. There are special considerations for the cash flow volatility of high tech firms in the model as well.rcmfinancial.com
