Comparison of EP and FCF

Topics: Discounted cash flow, Weighted average cost of capital, Cash flow Pages: 6 (1741 words) Published: November 26, 2013

1 Abstract
When appraising an investment, it’s necessary to find the right valuation method do apply based on the internal and external conditions. This paper will focus on the differences and similarities when using the economic profit (EP) or the discounted cash flow (DCF) method when appraising an investment. When applied correctly, both valuation methods yield the same result; however, each model has certain benefits in practice. The DCF method uses future cash flows projections and discounts them with a suitable rate in order to calculate the present value of the investment. The economic profit input is less than DCF valuation. The metric needs data extracted from income statement and balance sheet to calculate the surplus value between NOPAT and capital cost rate. Given that the two methods yield identical results and have different but complementary benefits, we recommend creating both DCF and economic-profit models when valuing an investment. 2 Introduction

When an investment is appraised, it is necessary to find suitable valuation methods to apply based on the company’s internal and external conditions. There are many different valuation approaches. However all those valuation methods can be categorized into 4 types based on the sources of input and valuation process. Figure 1 shows the list of the four main valuation approaches and different models involved in each approach (B. Steens 2013, sheet page 79).Figure: 1 Among the many ways to value an investment, the next chapter focuses particularly on two, DCF and discounted economic profit. When applied correctly, both valuation methods yield the same results; however, each model has certain benefits in practice. DCF remains a favourite of practitioners and academics because it relies solely on the flow of cash in and out of the company, rather than on accounting-based earnings. The discounted economic-profit valuation model is gaining in popularity because of its close link to economic theory and competitive strategy. Economic profit highlights whether a company is earning its cost of capital and how its financial performance is expected to change over time. 3 Valuation Techniques

The basis for the valuation principles starts with a couple of assumptions. Firstly, a company should separate its non-operating assets and operating assets. Operating assets are fundamentally the principal sources of a company‘s cash flows. The valuation of operating assets applies two different fundamental concepts: a liquidation assumption and a going concern assumption. Most of the analyses, value a business as a going concern1. Normally, the use of valuation models in investment decisions is also based upon the assumption that markets are inefficient.2 In an efficient market, the market price equals the company value and the purpose of a valuation model is the only justification of this value. No investor can use any technical analysis to beat the market. There are a couple of things to keep in mind regarding the similarities and differences between economic profit valuation and free cash flow valuation. EP and DCF valuation models must produce the same intrinsic value of the firm and its common stock. However EP valuation provides managers and investors with a direct measure of how the firm creates or destroys shareholder value as reflected in NPV. The second observation pertains to the capital charge on invested capital. Specifically, in the economic profit approach to securities valuation an explicit charge on the beginning of year capital is assessed each year and deducted from NOPAT. In contrast, in a free cash flow model, the present value of the capital charge on the firm’s periodic investment is implicitly recognized in the year that the capital expenditure is incurred. In 3.1 and 3.2 we will further describe the DCF and EP methods, also weighing the advantages and disadvantages...
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