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Pasquale De Luca Analytical Corporate Valuation Fundamental Analysis, Asset Pricing, and Company Valuation Analytical Corporate Valuation Pasquale De Luca Analytical Corporate Valuation Fundamental Analysis, Asset Pricing, and Company Valuation 123 PasqualeDe Luca Department ofLaw andEconomics ofProductive Activities Sapienza University of Rome Rome, Italy ISBN978-3-319-93550-8 ISBN978-3-319-93551-5 (eBook) https://doi.org/10.1007/978-3-319-93551-5 LibraryofCongressControlNumber:2018954045 ©SpringerNatureSwitzerlandAG2018 Thisworkissubjecttocopyright.AllrightsarereservedbythePublisher,whetherthewholeorpart of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission orinformationstorageandretrieval,electronicadaptation,computersoftware,orbysimilarordissimilar methodologynowknownorhereafterdeveloped. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publicationdoesnotimply,evenintheabsenceofaspecificstatement,thatsuchnamesareexemptfrom therelevantprotectivelawsandregulationsandthereforefreeforgeneraluse. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authorsortheeditorsgiveawarranty,expressorimplied,withrespecttothematerialcontainedhereinor for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictionalclaimsinpublishedmapsandinstitutionalaffiliations. ThisSpringerimprintispublishedbytheregisteredcompanySpringerNatureSwitzerlandAG Theregisteredcompanyaddressis:Gewerbestrasse11,6330Cham,Switzerland A Dadi, che mi ha fatto scoprire la più bella e misteriosa delle equazioni, quella dell’amore. Preface Without a doubt, finance has undertaken a central role in the strategic governance of the company. In the recent decades, finance has been characterized by a strong development in the passage from a marginal and subordinate role compared with theotherprimarydivisionstoacentralroleincompanygovernance.Today,finance is not only strictly related to these classical divisions by influencing their choices and their operating processes, but also it is increasingly able to influence the company’s strategies and it is not unusual that it can in itself represent the starting point of new strategies and business models. This central role of finance in the life of a company is undoubtedly the result oftheglobalizationprocessandthecorrelatedstrong,fastanddeepdevelopmentof capital markets that have changed the development of economic models and then the company’s business model. Theroleoffinanceanditscontributionisincreasinglyimportantforthesurvival and development ofthecompany overtime. Finance has already changed andwill probably change more and more together with its paradigms, strategies and oper- atingprocesses.Today,andevenmoreinthefuture,itisdifficulttoimaginedoing business without doing finance as well. This book is based on a shareholder-oriented capitalism. Consequently, the companycanthriveonlyifitisabletocreatevaluefortheshareholdersovertime. IntheGreatRecessionperiodasderivedfromthefinancialcrisisof2007–2008,this approachcouldbeunpopular.Indeed,incommonsenseandinapartofacademics the recent financial crisis isusually charged to the shareholder-oriented capitalism. Thisisespeciallytrue inEuropefor economicandbusinesscultures. Ibelieve that thefinancialcrisiscannotbeattributedtoashareholder-orientedcapitalismbuttoa particulardistortion.Theproblemisthetransferfromthelong-termperspectivetoa short-term perspective. It is in contrast with one of the most relevant fundamental principles in the shareholders' value creation perspective that states the company’s capability to create shareholders’ value in the long-period is not the same as the maximization of its short-term profits. Often the choice of maximizing the share- holders’ value in the long-term perspective is irreconcilable with the choice of maximizing the shareholders’ value in the short-term period. Consequently, if the vii viii Preface value creation in the long-term is confused with the profit in the short-term, it generatesagreatproblemcapableofdamagingshareholders’interestsaswellasthe stakeholders’interests.Therefore,themainproblemofthefinancialcrisisisnotthe shareholders’ value perspective but the short-term perspective of some managers. The company’s ability to create value for the shareholders over time is strictly related tothedeep understanding ofthebusinessmodel of thecompanyas well as the investors’ behaviour in the capital markets. The company valuation can be considered one of the most relevant fields in which the classical paradigms of the company meet the paradigms of the capital markets. Indeed, the right company’s valuationrequireshighcompetenceinthefieldsofstrategy,financialmanagement, corporate finance and capital markets. ThebasicequationofthevalueisbasedonaprinciplethatdatesbacktoAlfred Marshall: a company creates value if and only if the return on capital invested exceeds its cost of capital. The amount of value is equal to the difference between cash-in flows derived fromtheinvestmentandthecostofcapitalinvestedabletoreflectthetimevalueof moneyandtheriskpremium.Consequently,tocreatevalueovertime,thecompany must invest the capital raised at a rate of return higher than its cost of capital. Therefore, there are two main variables of value creation: – the return on capital invested; – the cost of capital. In this book, the company’s ability to invest the capital raised by obtaining a highreturnisinvestigatedthroughananalysisofthecompany’sfundamentalswith regardstoitsbusinessmodelanditseconomicandfinancialperformanceovertime. Specifically, the return on capital invested in the business is function of the company’sbusinessmodelandthequantitativeeffectsofthestrategicchoicesonits economic and financial dynamics. Specifically, the company’s ability to create profit over time requires an analysis based on two main parts: – the qualitative analysis of the business model; – thequantitativeanalysisofthecompany’sperformancewhichregardstheeffects of the business model choices on the economic and financial dynamics over time. Otherwise,thecompany’scostofcapitalinvestedinitsbusinessisderivedfrom theinvestors’behaviourandtheiranalysisoftherisk-returnprofileofthecompany in the capital markets. The cost of capital for the company is one of the most relevanttopicsformanagersandfinancialeconomists,anditplaysacentralrolein thevaluationmodelsofthecompany.Fordecades,severalstudieshavefocusedon the relationship between capital structure, cost of capital and company value. Despite a broad experience approach in both academic and practices, it should not be surprising that the method for estimation of the cost of capital is still under intensive discussion. Preface ix An estimation of the cost of capital for the company is based on the investors’ behaviourandexpectationsinthecapitalmarket.Itrequirestheknowledgeoftheir modelsabouttheriskvaluationandtheexpectedreturnsestimation.Thegreaterthe managers’skilltounderstandtheinvestors’behaviourandtheirchoices,thegreater the company’s probability to satisfy the investors’ expectations by acquiring the capital required for its development at favourable conditions. Specifically, the cost of capital is function of the asset pricing in the capital markets. It is the function of the investors’ models about risk diversification and returns maximization, and thus, it can be derived by general equilibrium model in the capital market. Based on these two variables, return on capital invested and the cost of capital, the company’s ability to create value over time for its shareholders is the function of the effectiveness of the Company Strategic Formula to create expected cash-flowsaswellasinvestors’modelstodiversifytheriskandmaximizeexpected returns in order to estimate the cost of capital. The basic equation of value states that the company creates value if and only if the return on capital invested exceeds its cost of capital. The explicit application ofthebasicequationcanberealizedthroughseveralmethodologies.Amongthem, the Discounted Cash-Flows model (DCF) is the best. It is commonly used in the financial community. It is relevant since all members of the international financial community use a common criteria and language. Byusing theDCFapproach,thecompanyvalue isequaltothecurrentvalue of expected future cash-flows and the cost of capital is used as a discount rate. Therefore, there are three main variables: – Time: the referenced time is the future. The value of the company is strictly related to future performance rather than past performance; – Cash-flows: company’s performance is measured in cash-flow terms. Specifically, the expected future cash-flows from operations and to equity; – Cost of capital: it is the cost of debt and the cost of equity, and it defines the discount rate for expected future cash-flows. The General Equation of Value can be defined based on these three main variables as follows: X1 CF WF ¼ ð1þktÞt ð1Þ t¼1 where WF is the company’s value; t is the period-time of valuation; CFt is the expected future cash-flows for each year (t); k is the cost of capital used as a discounted rate. Equation (1) has a great theoretical relevance. It estimates the value of the company based on expected cash-flows, arising from the fundamental analysis of the company and the cost of capital. Also, the equation defines the relationship x Preface Strategic Formula - Qualitative Analysis - Fundamental Analysis of the Expected Equity Company Cash Flows Valuation Economic and Financial Discounted Dynamics Cash Flow - Quantitative Analysis - Models Enterprise Risk and Returns Equilibrium Cost of Valuation Asset Pricing Measurements Models Capital Fig.1 Methodologicalapproach betweencompanyvalue,theexpectedcash-flowsandthecostofcapitalinthetime of valuation. The integration between models on company’s fundamentals from which the expected cash-flows are derived and the investors’ models about risk and return in the capital market by which the cost of capital for the company is derived can be summarized as follows (Fig. 1). Theintegration betweenthecompany’sfundamental analysis andtheinvestors’ models of risk and returns in the capital markets is essential for the company’s success over time. It is not possible to fully understand the company’s ability to create value over time and to measure this value without the simultaneous deep knowledge of these models and their integration. Consequently, the managers must define their strategies and operational pro- cesses by considering the business and industrial logics with regard to customers, suppliers, competitors, as well as the financial criterion with regard to investors in equity and debt. Therefore, clear thinking about drivers of the company’s value creation as well asarightapproachtoitsmeasurementrequirestwomainskills:(i)theanalysisand evaluationofthecompany’sfundamentalswithregardstoitsbusinessmodelandits performances over time; (ii) the knowledge of the investors’ models about risk diversificationandreturnsmaximizationfromwhichthecostofcapitalforthefirm is derived. To integrate the company’s fundamental analysis and the investors’ models about risk and return in the capital markets with reference to company valuation, the book is characterized by a large recourse to a rigorous quantitative analysis. Specifically, the methodological approach used in this book is based on: – mathematics, to assure the consistency of models in its construction; – graphics, to provide intuition; – words, to explain the results and the economic significance. The large use of a rigorous quantitative analysis to integrate the company’s fundamental analysisand the investors’models about risk andreturn inthe capital marketsinordertothecompanyvaluationisnottocomplicatetheanalysisbut,on the contrary, to simplify the discussion. There are three main reasons. Preface xi – first, models are easier to understand if they are studied in their formal con- struction.The mathematical form allows ustofurtherunderstand themodelsin their construction, assumptions and, then, in their clear capabilities and limits; – second,themathematicalformdoesnotallowinappropriatemanipulationofthe equations and, consequently, an incorrect use of the models. Every equation is the result of a rigorous formal process and their modification can be realized only by following the same rigorous formal process; – third, the mathematical form does not allow for attribution of the equation meaningsthatarenotsupportedbytheirstrictformalderivation.Everyequation acquires form and meanings strictly related to the mathematical process of derivation. The clear derivation step-by-step of each equation does not allow errors in the equations interpretation and, consequently, in the use of models. Rome, Italy Pasquale De Luca June 2018

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