FINDING VALUE WHERE NONE EXISTS: PITFALLS IN USING ADJUSTED PRESENT VALUE

Abstract

There are several conceptually “correct” methods for valuing firms and projects, including the weighted average cost of capital (WACC) approach, the flows to equity (FTE) method, and the adjusted present value (APV) or valuation‐by‐components method. The author examines the relative advantages of these frameworks and offers guidance as to when they are likely to be most useful. The key message is a caution to would‐be users of APV: it is frequently unreliable and should be used only in conjunction with more conventional valuation frameworks. It works best in transactions that involve structured financings, such as leveraged buyouts and project and real estate financings. Even in these cases, however, its usefulness depends on theoretical concepts that in practical applications have a wide margin of error.In general, WACC is a robust and appropriate valuation framework as long as the firm has a target debt ratio. The FTE method is most relevant for acquisitions and very large projects. The author shows how APV and FTE can be formulated to be consistent with the WACC valuation. The issue, however, is not whether the techniques can be made consistent through relatively complex adjustments by sophisticated users, but rather what happens when they are used in everyday applications by practitioners unfamiliar with the somewhat arcane valuation issues involved.