Corporate valuation and risk

The present book aims to delve deeper into firm value and risk. Such two items (firm value and risk) are strictly interconnected, as the firm value measurement requires risk-return analysis necessary for the cost of capital estimation. In general, these topics play a crucial role in the view of various economic actors, particularly during periods of turbulence induced by policymakers, business decision-makers, and individuals, including financial advisors, financial investors, corporate managers, independent practitioners, and public policymakers. Indeed, the firms’ capacity to generate economic value and manage their risk profile arises as fundamental pillars in wealth creation at the micro and macro levels. We address firm value creation and risk-return analysis by focusing on traditional theories primarily derived from finance studies, as well as innovative models and methods from a managerial perspective. The basic idea behind the present book is to apply a process based on the composition and decomposition of individual determinants that matter in firm value assessment. This mixed approach fosters a firm’s evaluation and risk-return analysis by making explicit both internal and external, as well as micro and macro, variables of the firm. It also defines a proper learning path from both theoretical and practical perspectives, as it enables understanding of the theoretical drivers of firm value and its risk-return profile, and for practically contextualizing this kind of analysis in relation to the type of firm, its environmental context, and stakeholders’ expectations. In this vein, the purpose of the book is to disseminate knowledge in the field, benefiting students, economic actors, and scholars who have an interest in both traditional and innovative approaches to firm valuation and risk analysis. The book is articulated in six Chapters. Chapter 1, “Firm value. General concepts”, introduces the topic of economic value and its determinants, distinguishing it from book value. It considers the basic valuation criteria in financial analysis, namely present value, net present value, and internal rate of return. The Chapter also examines the relationship between consumption and the time factor, as outlined in Fisher’s Interest Theory and the related Separation Theory. It concludes with an introduction to the concepts of cost of capital and risk premium. Chapter 2, “Capital structure, profitability, and firm value”, considers the role of capital structure in defining the effects on profitability, firm value, and the risk-return trade-off. The transition from an accounting capital structure to an economic one lays the conceptual foundations for understanding the interrelationships between capital structure, cost of capital, and firm value. Finally, the chapter examines value creation processes and fundamental financial theories regarding the relationship between capital structure, cost of capital, and value. Chapter 3, “Basic firm valuation methods”, examines how the primary valuation methods can be used to estimate the economic value of a firm, describing the estimation details and possible limitations. Starting from the general valuation formula represented by the Dividend Discount Model and the Gordon model, the chapter examines the application profiles of the Discounted Cash Flow method, the Adjusted Present Value Method, and relative valuations based on multiples. Chapter 4, “Risk-return analysis and equity cost”, focuses on risk-return analysis to introduce the estimation of the cost of equity capital. The Chapter traces the evolution of financial theory on the risk-return trade-off, starting with Markowitz’s Portfolio Theory, continuing with Tobin’s Separation Theorem, and ending with the Capital Asset Pricing Model. Although the latter is a milestone in financial theory that remains the approach most widely adopted by both financial advisors and internal corporate analysts in several valuation areas that require the measurement of the equity cost of capital, the Chapter concludes with an examination of some alternatives to the Capital Asset Pricing Model. Chapter 5, “Risk-return analysis according to a managerial perspective. The bottom-up approach”, considers, through integrative modeling of strictly financial models, the risk-return profile of each firm not only in terms of statistical volatility, but also by explicitly identifying the internal and external factors that determine volatility according to a bottom-up approach. This enables the integration of rigid financial logic by incorporating managerial issues into the risk-return analysis from both static and dynamic perspectives. Chapter 6, “The value of flexibility. Financial options and real options”, describes in general terms the economic utility of flexibility as a tool for dynamically managing the uncertainty arising from financial and managerial decisions. The chapter examines financial options and related basic pricing models, then focuses on real options, which are typical instruments of managerial flexibility that enable management to adjust the course of an investment project after observing the dynamics of actual independent variables.