June 23, 2011
Corporate Finance Roundtable: The Lingua Franca of Business
Posted by Karl Okamoto

I see the concept of valuation as built around the core concept of present value. Why is a 10-year bond paying simple interest at an annual rate of 10% worth $1,134 in a world where comparable bonds are issued at par with an 8% coupon? If you understand present value, you can answer that question. Bonds are worth the sum of the present values of their future cash flows – interest and the return of principal at maturity. The same approach – discounting cash flows – is the essence of valuation.

So what about CAPM? Or the Efficient Market Hypothesis? Most assets (whether they be publicly-traded equities, entire businesses or the role of lead counsel in a plaintiff’s class action) are a bit more complicated than a straight bond. So challenges like risk and the volatility of future payments call upon more sophisticated techniques than simple NPV calculations. And finance’s efforts to build models that can handle (over-simplify?) these complexities is certainly fascinating stuff. Anyone who cares about financial market regulation should understand these ideas. But I like to teach valuation as a story of slightly more complicated bonds.

Why? Because valuation is the lingua franca of clients. Exit values, EBITDA multiples, and IRR are what business folks care about. They buy a building because of the “good cap rate.” They buy stock because of the “arbitrage.” They sell a business because of the poor return on assets. And so on. All of these concepts are about cash flows and valuation. They are about more complicated bonds.

Most business folks I know don’t believe in efficient markets (because they are not good places to make money). But valuation is their religion. Lawyers need to understand it.

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