A good starting point is to look at risk and reward when deciding whether one should invest in a proposition and if so, decide what to invest for the expected return. One approach is to use the future free cash flow generated by the proposition to underpin its present value.

Assuming the proposition generates an annuity of S$100 till perpetuity and the hurdle rate[1] ( to compensate for the perceived risk ) is 10% p.a.. The question to ask: what would one be willing to pay for such a cash flow stream? The present value of the cash flow is 10x its annuity value and this works out to be $1,000. As an investor and having a risk appetite that generates a return of 10% p.a. one would not be willing to pay more than $1,000 for the proposition.

Why?                                                                                                      

Putting down $1,000, one gets an annual return of $100 ( 10% ) and at the end of its life getting back principal of $1,000 in the far out years ( although the present value will be nothing ).

Embedded in this connection are the risk-adjusted return[2] ( 10% p.a. ), cash flow, present value components, and key ingredients when deciding whether to invest.

This same approach can be applied to enterprise valuation by examining its future free cash flow, weighted average cost of capital ( risk-adjusted measure ) to determine its enterprise value and equity value if the net debt value is stated. With the same set of numbers, the enterprise value and equity value will work out to be $1,000 assuming no net debt.

Assuming the risk measure for the business model remains unchanged if the yearly free cash flow were to decline to $50 from $100, the implied enterprise value / equity value would be S$500. There would be a value destruction of $500 for the investor.

From the above, one can surmise that value is created when the actual return on the initial investment exceeds the risk-adjusted hurdle rate. Conversely, value is destroyed when the actual return falls below the risk-adjusted hurdle rate.

We can apply the above example to the real word by decomposing the initial investment to its core components so as to understand how these components connect to one another to make up a business model that is capable of generating sustainable cash flow.

This can be achieved by mapping the value chain processes encompassing vision and strategic thinking making it possible to quantify future free cash flow that underpins actual enterprise value. We will need to go beyond the realm of financial domain and would in most cases cover the following areas[3].

External

• market / industry,
  • environmental factors
  • growth potential
  • business cycle
  • barrier to entry
• competitive position,
  • marketing strategy
  • market share
  • product differentiation
  • technology content
  • competitive strengths

Internal

• management/controls,
  • quality
  • integrity
  • competence
  • risk mitigants

Such a framework will allow us to gain insights and assess the quality of the value chain processes and hence its value creating potential. In the next post, we will cover: What counts is the qualitative aspect of value creation.

[1] The hurdle rate is not risk measure. The volatility ( standard deviation ) is the measure of risk

[2] Use the CAPM to benchmark risk e.g. r_e = r_f + b*( r_m – r_f ) http://www.investopedia.com/terms/c/capm.asp

[3] “…clear and understandable way to tell stakeholders how board has applied the minds collectively to the sustainability issues relevant to the business of the company, while giving stakeholders a long term strategy for as far ahead as 20 to 30 years.” http://www.ft.lk/2014/05/26/prof-mervyn-king-champions-integrated-reporting-at-ca-sri-lanka-sec-corporate-directors-program-launch/