A Fresh Approach to Company Valuation
Chances are good that you’ve pondered this question at some point, perhaps in an MBA class or as part of your daily work: What is the fundamental value of a company?
Chances are also good that you’re familiar with the standard formula for answering that question—the present value approach, which posits that the value of a company is equal to the present discounted value of all its future cash flows.
As Assistant Professor Frederico Belo explains, that formula is fine in theory, but extremely difficult to implement in practice. In its place, he offers new research that provides an alternative approach, one which examines the actions of a company’s managers and uses that information to calculate the organization’s true value.
“The idea is simple—we know that a manager will try to invest to a point where marginal cost equals marginal benefit,” Belo explains. “If managers are behaving optimally, they will make investments such as purchasing new computers until the marginal cost of the investment—which factors in disruption costs such as the cost of installing the new computers—are equal to marginal benefit of the investment.”
The key is that by observing the rate at which managers invest, outside investors can surmise the marginal value of the capital in the company—which offers a strong clue to the company’s value.
“The traditional method of company valuation doesn’t allow for temporary misalignment between investment data and market prices. They don’t always synch up, and there will occasionally be mispricing. Our approach allows for that.”
Belo notes that the most complicated step of the standard approach to valuation lies in estimating future cash flows. Using manager behavior as a measuring stick eliminates the need for such estimates—and provides a more easily implementable and potentially more accurate picture of a company’s worth.
While Belo’s research confirms the accuracy of his approach, he says it’s not necessarily a replacement for the present value approach. Rather, he counsels using the two in conjunction with each other. “The two can be complementary,” he says. “They’re best used as a cross-check of sorts against each other.”