Capital Ideas: Back to the Future of Valuation

The inventor of a new valuation model claims to have a roadmap for value creation that includes signposts on how to set, track, and meet growth goals.

Tucked into chapter nine of a new book about business valuation is a future-value equation — a methodology to show the fair-market value (FMV) of a business as of a future date. I point this out for two reasons, neither being my love of advanced algebra.

First, the equation, which is found in the recently published Value Your Business and Increase Its Potential (McGraw-Hill Companies), isn’t simply descriptive (the company is found to be worth $100 million). Rather, it can be used as a management tool to bridge the gap between valuation mathematics and management know-how.

Further, using the tool can force managers to think differently about value creation. Indeed, the equation comprises all the key elements of a company’s financial statements and mathematically relates them to one another. That interplay means managers can set future growth targets and then measure the progress of meeting or missing those marks.

But to the uninitiated, none of that is apparent at first glance.

To be sure, the meanings of some of the finance terms are easily decoded: Inc, income; g, growth rate; Cap Expend, capital expenditures; Depr, depreciation; Incr NWC, increase in net working capital; and r, discount rate. But I wanted to decipher what’s unique, and useful, about the equation, so I asked its inventor, valuation guru Jay Abrams, president of Abrams Valuation Group in North Hollywood, California, as well as other specialists.

In a nutshell, the formula is about the future, although it’s more Miller and Modigliani than H.G. Wells. Traditional valuation methods, by contrast, focus on net present value (NPV), which useful for valuing a company for purposes of a merger, tax work, or litigation but doesn’t help executives create future value.

The future-value equation is consistent with the economic theories of Nobel laureates Merton Miller and Franco Modigliani, as laid out in their 1961 treatise “Dividend Policy, Growth, and the Valuation of Shares,” notes David Kleinman, a valuation expert and management professor at the University of Chicago. Specifically, says Kleinman, the treatise concludes that a company’s value is tied to a trio of metrics: cost of capital, growth rate, and rate-of-return on invested capital.

Abrams’s equation incorporates those metrics, along with other key elements of a company’s financial statements: the past year’s income, growth in cash flow, profit margin, and retention ratio (the part of net income not paid out as dividends).

With his equation, Abrams aims to paint a picture for managers about what they can do today to affect the value of their company many years from now. For example, consider the cash-flow section of the equation (which is set apart from the rest of the calculation by brackets.) This portion represents a way to calculate a company’s retention ratio, which is the percentage of net income that a company must retain to spur growth.

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