Discussions on financial models are both futile and essential. Futile because there is nothing to discuss; the only way to value an operating asset is to discount its free cash flow into perpetuity. Essential because outsiders – such as financial analysts – lack information to calculate this accurately. Therefore they need a solid, sensible and accurate framework to approximate this Net Present Value in order to frame the issues by raising the right questions. It is the talent of the analyst, not the model, which is expected to give the answers.
We are users, advocates and developers of Residual Income Models across all our research output, because we find this framework simple yet pertinent, and better suited to corporate analysis than other more “financial” models.
We like its reliance on a precise definition of capital invested, which we call Economic Capital – an essential variable. Economic Capital can be seen as the aggregate amount of historical capital investments in use by management (e.g. still economically viable) and owned by shareholders.
We like how the Residual Income framework lends itself to a clear and powerful analysis of Value Creation in the definition of Economic Profit, which considers the Cost of Capital as an Operating Cost and deducts it from Operating Earnings.
The traditional break down of Enterprise Value into Equity and Operating Liabilities has limited information, we think, apart from the obvious: the computation of financial gearing. This is because it focuses on the liability side of the balance sheet, which carries limited economic information.
In order to take investment or strategic decisions, we prefer a more dynamic, asset-focused analysis on the three sources of value: Asset, Franchise and Growth.
We define Intrinsic Value as the sum of Asset Value and Franchise Value; we believe, on average, that investment analysis should focus primarily on this aggregate. We view the Growth Value as a welcome bonus but are reluctant to pay for it, except in rare cases.