wouldneedtoadjustthebetaaccordingly.Whilethiscanbe
donesimplyifyouusebottom-upbetas,youcanseethatit
wouldbemuchmoredifficulttodoifyouobtainabetafrom
a regression.
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2.Asthefirmgrows,theproportionofincomethatisderived
fromoperatingassetsislikelytochange.Whenthisoccurs,
youhavetoadjusttheinputs tothevaluationmodel—cash
flows, growth rates, and discount rates—to maintain
consistency.
Whatwillhappenifyoudonotmaketheseadjustments?You
will tend to mis-value the financial assets. To see why,
assume that you were valuing the steel company just
described,with 10 percentofitsincomecomingfromcash.
This cash isinvestedin government securities andearns a
risk-freerateof,say, 2 percent.Ifthisincomeisaddedtothe
otherincome ofthefirmand discountedbackata cost of
equityappropriateforasteelcompany—say 11 percent—the
valueofthecashwillbediscounted.Abilliondollarsincash
will be valued at $800 million, for instance, because the
discount rate used is incorrect.
Separate Valuation
It is safer to separate cash and marketable securities from
operatingassetsandtovaluethemindividually.Wedothis
almost always when we use approaches to value the firm
ratherthanjusttheequity.Thisisbecauseweuseoperating
incometoestimatefreecashflowstothefirm,andoperating
income generally does not include income from financial
assets.Onceyouvaluetheoperatingassets,youcanaddthe