What is an Incremental Investment Dollar Worth?

Whether you are an employee, a business owner, or a shareholder, you may have wondered what an incremental dollar of investment is worth to your company.

First it depends upon the cost of funding (F%) for an incremental dollar of investment ($I), and second the return (R%) that you earn on that incremental dollar of investment.  The dollar value ($V) created by the dollar of investment is simply $V = $I*(R% – F%), and the return (RI%) on the dollar of investment is RI% = R% – F%.

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Assessing Enterprise Risk Via Free Cash Flows

When looking at a company, from the smallest sole proprietorship to the largest multinational corporation, how does one assess risk?  Risk is simply the uncertainty (fluctuations) of the free cash flows being generated by the company.  This means that a company is only as good as its assets that are in place (including human assets), since these assets are what produces the firms revenue and expense, and ultimately the company’s free cash flows.  CapEx investment is thus critical because it sets your assets in place, and ultimately determines the risk of the enterprise via the NOPAT that the assets generate, and by the level of CapEx that is required to sustain and to grow the enterprise. Continue reading “Assessing Enterprise Risk Via Free Cash Flows”

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Gordon Dividend Discount Model (DDM) versus FCF Valuation Model

Two popular models for valuing equity are the DDM and FCFS models.  The DDM is sometimes referred to the Gordon constant growth model, because it assumes the firm is growing at constant growth rate.  Both of these models are perpetuities of cash flows that have been paid to the shareholder (i.e., D0) or cash flows that are available to be paid to the shareholder (i.e., FCFS0).  So not only do both models rely on constant growth, but also constant growth to infinity.  Some may question the reality of a firm ongoing to infinity, but consider that after about 30 years, the cash flows are near zero due to discounting, and a firm paying dividends for 30 years is very plausible. Continue reading “Gordon Dividend Discount Model (DDM) versus FCF Valuation Model”

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How to use the CAPM and Beta

In a world where non-linearity and randomness are the norm, the capital asset pricing model (CAPM) is widely accepted despite it being a linear model, and this is probably due to the simplicity of the model and its pre-computer age birth (see equation below).  A well recognized and utilized metric in finance is beta (β), which is the slope in the linear CAPM.  To derive β one simply plots the returns (capital gains plus dividend yields) of an individual stock (y-axis) against the returns of a well diversified portfolio of stocks ( x-axis), with the resulting slope being called β.  Thus β represents the risk associated with an individual stock, as it is compared to a well diversified portfolio, and since the market portfolio theoretically only contains market risk, a β above (below) one reflects the degree of company-specific risk of the individual stock that should be diversified away as it is added to the market portfolio. Continue reading “How to use the CAPM and Beta”

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