followthefirm.Thebiasassociatedwithboththesesources
should raise questions about the resulting valuations.
Inthis book,we promotea thirdway,where theexpected
growthrateistiedtotwovariablesthataredeterminedbythe
firmbeingvalued—howmuchoftheearningsisreinvested
backintothefirmandhowwellthoseearningsarereinvested.
Intheequityvaluationmodel,thisexpectedgrowthrateisa
productoftheretentionratio—thatis,theproportionofnet
incomenotpaidouttostockholders,andthereturnonequity
on the projects undertaken with that money. In the firm
valuationmodel,theexpectedgrowthrateisaproductofthe
reinvestment rate, which is the proportion of after-tax
operatingincomethatgoesintonetnewinvestmentsandthe
returnoncapitalearnedontheseinvestments.Theadvantages
ofusingthesefundamentalgrowthratesaretwofold.Thefirst
isthat theresultingvaluations willbe internally consistent
and companies that are assumed to havehigh growth are
requiredtopayforthegrowthwithmorereinvestment.The
secondisthatitlaysthefoundationforconsideringhowfirms
can make themselves more valuable to their investors.
Discounted Cash Flow Valuation: Pluses and Minuses
Totruebelievers,DCFvaluationistheonlywaytoapproach
valuation,butthebenefitsmaybemorenuancedthattheyare
willingtoadmit.Ontheplusside,DCFvaluation,doneright,
requiresanalyststounderstandthebusinessesthattheyare
valuingandasksearchingquestions aboutthesustainability
of cash flows and risk. Discountedcash flow valuation is
tailor-madeforthosewhobuyintotheWarrenBuffettadage
thatwhat we arebuyingare notstocks butthe underlying
businesses. In addition, DCF valuation is inherently