Why is a firm valued by future operating earnings only?
It seems valuation as I have learned it focuses on valuing a company's operating potential, but surely $10bn of non-operating assets (property say) are not irrelevant and add value in their ability to generate cash when sold?
You're not wrong. You value a firm based on both. In a DCF, for example, you'd take the future cash flows of the business -- which are generated by the operating assets -- and add that discounted value to any non-operating assets (eg excess cash). Real estate is a bit trickier -- for example, a retailer can lease instead of own its property. In the case where you would want to explore the value of the business by treating the real estate as a non-operating asset (ie a REIT separation and spin), you'd have to discount the operating cash flows accordingly by what the lease payments would be.
But I think that's pretty clear by the typical formula of DCF + Cash - Debt...so either your teachers suck or you're not reading their material correctly. Either way, your intuition is right.
Thanks - great answer.
I don't study finance (basically no-one in the UK does) so I have been self-learning and so far I had led myself to believe 'EV = DCF'. 'EV = DCF + Cash - Debt' makes more sense.
Sorry, I've been drinking. I need to clarify that is for equity value.
equity value = Cash + Non-operating Assets + Operating Assets - Debt
Enterprise Value = Operating Assets = equity value - Cash - Non-Operating Assets + Debt
The former is intuitive, the latter a little less so. But think of Enterprise Value as the effective price of buying an entire business. You can use the cash and sell off the non-operating assets to fund your purchase, and you'd still have the same business with the same cash generating potential.
Thanks for clarifying. My question was basically, why does EV = Operating Assets? Is a business A worth the same as an identical business B, but where B has $10bn in cash? Surely you would have to pay $10bn extra for B? The same goes for non-operating assets?
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