Enterprise valuation with track-record ratios and rates of change

Abstract

This paper proposes and tests a variant of the standard discounted cash-flow model for enterprise valuation. The cash-flow (C/F) stream to be discounted is projected as the product of the sales and the free C/F to the enterprise (FCFE)-to-sales ratio and their respective rates of change. The C/F timespan is divided into three intervals. In the first, sales and ratio change according to the company's track record. On the assumption that both industry and firm abnormal earnings disappear at a certain point, marking the beginning of the third interval, the ratio evolves over the second interval to reach the Industry's average and thereafter remains constant. On the same basis, sales grow in the third interval in accordance with the economy's long-term trend, i.e. at the long-term nominal GDP growth rate, and within the second at an average of the latter and the track-record year-on-year growth rate. The proposed variant is tested for the four largest telecommunications companies in continental Europe over a 2.5-year period. The results, together with those of the standard model, are then compared with enterprise market values to test relative performance. Examination of their respective bias (signed valuation errors) and inaccuracy (ditto unsigned) seems to indicate that the proposed variant outperforms the standard model from which it is derived, even for different assumptions about the valuation horizon and for alternative ways to estimate the values of the variables. © 2010 Taylor & Francis.