Principles of Private Firm Valuation

usually requires the firm to increase internal investments or net new capital
expenditures beyond what it has historically done. Depending on the strate-
gic thrust, management may decide that buying is cheaper than building and
therefore decide to commit itself to an acquisition or series of acquisitions.
Such external investments might be accompanied by divestitures of business
units that no longer fit with the firm’s core business strategy.

MEASURING THE CONTRIBUTION
OF STRATEGY TO FIRM VALUE

Figure 2.1 shows that a firm’s value is the sum of the values created by var-
ious strategic initiatives. The aggregation of these values is equal to the
value of the firm, which is also equal to the sum of the market value of the
firm’s equity plus the market value of its debt. Moving counterclockwise,
the no-growth value is made up of the value of assets in place. This value is
equivalent to capitalizing the firm’s current cash flow by its equity cost of
capital. In this case, each year’s gross investment equals annual deprecia-
tion, so the assets in place are always sufficiently maintained to provide the
required cash flow. Thus, if a firm’s annual after-tax cash flow is $1 million
and the firm’s cost of equity capital is 10 percent, then the firm has an equity
market value of $10.0 million ($1 million ÷0.10). If the firm has 1 million

Creating and Measuring the Value of Private Firms 11

Continuing to operate at

historical growth rate =

business as usual or

going-concern value

Value to

a new

owner

market

value

Adjusted cash

cow value = no

growth with

optimal

capital

structure

Internal

investment in

excess of

historical growth

with optimal

capital

structure

Internal

and external

investment at

optimal capital

structure

Cash cow value

= no growth

value/all

equity

$1,500

$3,500

$1,000 $3,000

$1,250 $1,750

1 Control value

Control options gap:

Value not recognized

6 Internal + external

growth value

Value

created by

external

activities

More Active

Strategic

Management

5 Internal

growth value

Value created

by internal

4 Business as usual or growth

going-concern value

Value created

by business as

usual

3 Adjusted cash

cow value

Value

created by

financing

Less Active

Strategic

Management

2 Cash cow

value

FIGURE 2.1 The Value Circle Framework