The relevance of Discounted Cash Flow (DCF) and Economic Value Added (EVA) for the valuation of banks

Table of Contents

Title Page

Declarations

Abstract

Acknowledgements

List of Exhibits

Glossary

Introduction

CHAPTER 1 RESEARCH METHODOLOGY
1.1 Investigation techniques
1.2 Definition of sample
1.3 Questionnaire design
1.4 Limitations

CHAPTER 2 THE DISCOUNTED CASH FLOW (DCF) APPROACH
2.1 The Shareholder Value Concept
2.2 Calculating Cash Flows
2.2.1 The Direct Cash Flow Calculation
2.2.2 The Indirect Cash Flow Calculation
2.3 Cash Flow versus Free Cash Flow
2.4 Fundamentals of DCF valuation
2.5 Techniques of DCF
2.5.1 The Entity Model
2.5.2 The Equity Model
2.6 The Price of Risk - Estimating appropriate Discount Rates
2.6.1 The Determination of the Cost of Equity
2.6.1.1 The Capital Asset Pricing Model (CAPM)
2.6.1.2 The Arbitrage Pricing Model (APM)
2.6.2 The Determination of the Cost of Debt
2.6.3 Combination of CoE & CoD using the WACC Approach

CHAPTER 3 THE ECONOMIC VALUE ADDED (EVA) CONCEPT
3.1 Background and relevance of EVA
3.2 Calculation of EVA
3.2.1 Special requirements in calculating NOPAT and Capital
3.2.2 Example of EVA calculation
3.3 EVA and Market Value Added (MVA) - The Link to DCF
3.4 Imperfections of the EVA concept
3.4.1 General Limitations of EVA
3.4.2 Efficient Market Hypothesis (EMH) and the CAPM

CHAPTER 4 FINDINGS AND ANALYSIS
4.1 Important aspects of bank valuation
4.2 Questionnaire review and presentation of findings
4.3 Analysis in relation to existing theory on DCF and EVA
4.3.1 Dividend Discount Model (DDM)
4.3.2 Valuation of Deutsche Bank with DDM
4.3.3 EVA & Bank Valuation
4.4 Summary

CHAPTER 5 CONCLUSION

References

Bibliography

Appendices
Appendix A Overview of Risk and Return Models
Appendix B The Beta Factor (ȕ)
Appendix C The Five Fundamental Factors of the APM
Appendix D Comparison of CAPM and APM CoE Estimates
Appendix E Measuring a Firm’s NOPAT & Capital
Appendix F The 2000 Stern Stewart Performance
Appendix G Case Study ‘DCF & EVA’
Appendix H Questionnaire on Valuing Banks (Blank Form)

List of Exhibits

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Glossary

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Abstract

This study investigates the underlying theories and assumptions of two modern capital market-based valuation approaches, the Discounted-Cash-Flow (DCF) and the Economic-Value-Added (EVA) approach, which are nowadays applied principally for industrial and manufacturing firms. This general examination is then transferred into a more specific investigation exploring whether these valuation concepts can be applied to the strongly regulated and more specific field of bank valuation. A questionnaire addressing bank analysts was created to analyse this question.

The project indicates that the ideas of shareholder value which have been enforced over the last decade have implemented the need for a more shareholder-focused valuation. The application of DCF is basically attributed to this movement. It is revealed that this concept uses cash flow streams which depict a more realistic picture of an organization’s true earning power. Moreover, it employs a discount rate based on the capital market and thus reflecting the yield expectations of the investors.

EVA, on the other hand is a relatively new concept, copyrighted in 1994 by Stern Stewart. It highlights an organization’s true economic profits. The study examines its components NOPAT, Capital and Cost of Capital, establishes a relation to DCF, points out some general limitations due to the fact that it falls back on accounting figures and critically assesses its dependence on the CAPM whose inherent assumptions of efficient markets that are not transferable into reality, might affect the valuation.

The primary research undertaken finally reveals that the concepts of DCF and EVA are basically suitable to be applied to the valuation of banks. However, there are some peculiarities, primarily due to difficulties associated with the definition and measurement of debt and reinvestments which make slight adjustments in the valuation process indispensable. Nevertheless, the end result is just as effective as in other industries.

Acknowledgements

I would like to take this opportunity to thank a number of people who have been supportive of the whole project and of invaluable help in attempting to steer the work in appropriate directions. Worthy of particular note in this context is primarily Tony Blackwood, my project supervisor, who was always willing to support me with his knowledge and comprehension in the months during my dissertation.

Furthermore, special thanks go to the analyst Stefan Klein of Cominvest who thoroughly responded to the questionnaire despite current reporting activities, Ron Pallas, who was always prepared to listen to my ideas and problems, Nicole who was always at my side and also to my room mates Marc, Thorsten, Oliver and Anna with whom I spent a wonderful time here in Newcastle. Finally, and by no means least, I would like to place on record the support of my parents who have always encouraged me to keep moving on, especially during the hard times of the sudden death of my loved grandpa, whom I would like to dedicate this project - Grandpa, I will never forget you!

Introduction

The importance of company valuation has steadily increased over the last decade. The necessity of valuing a company is in accord with the dynamic growth of company transactions and the significance of the capital markets. In both cases the concept of company valuation constitutes a crucial aid for investment decisions. However, the logical question which appears when considering valuation is inevitably how has the value been calculated and does its price really reflect the expectations of the market. With this in mind, the following study will lay its emphasis on two modern capital market-based valuation approaches - Discounted Cash Flow (DCF) and Economic Value Added (EVA) - and try to establish a sound understanding of their inherent concepts which are connected to the expectations of the capital market.

Talking about company or performance valuation also raises the question of who might be interested in the resulting numbers. A more general answer would clearly address all stakeholders, i.e. groups of people who are affected by or can affect an organization’s activities, such as shareholders, debtholders, customers, employees, suppliers or management. However, from a more accurate perspective the answer would primarily address capital providers and thus, principally shareholders who have invested in the company in order to achieve adequate returns.

Over the last ten to fifteen years which have shown a significant increase of public traded companies, the notion that a company’s principal goal should be to maximise shareholder wealth, and hence shareholder value has been reinforced. Nowadays, the involvement of the expectations of the capital market, i.e. capital providers, has become a crucial element for the valuation purpose. Modern approaches, such as DCF and EVA have emerged which try to capture exactly these claims of the capital market.

However, in order to adequately apply these models, simplifications of the complex economic reality are indispensable.

“ Any economic model is a simplified statement of reality. We need to simplify in order to interpret what is going on around us. But we also need to know how much faith we can place in our model ” (Brealey and Myers 2000:199).

With this in mind, the author will address some major imperfections in order to prove if such capital market-based approaches can really guarantee a more reliable company valuation. Moreover, following the investigation into DCF and EVA, this study will analyse if these valuation concepts, which usually aim at industrial and manufacturing companies, are transferable to the more specific requirements of the banking industry and what potential problems might be encountered.

In the end this project will have undertaken a thorough assessment of two modern capital market-based valuation approaches indicating the most appropriate one in the future and also answered the question whether they have any relevance for the strongly regulated and very specific field of bank valuation.

Chapter 1 Research Methodology

1.1 Investigation techniques

The research methodology applied in this project can be described in two successive stages.

Stage one will seek to explore the topic through a comprehensive review of the theories associated with DCF and EVA to be presented in chapter two and three. The research process involved in this stage was exclusively based on secondary information. This it due to the fact that the author could use the expertise of some highly respected finance and strategy consultancies, such as, Damodaran, Rappaport, Copeland, Hamel, Stewart and several others. Hence, the information that will be provided in the next two chapters strongly relate to practice and have therefore a high relevance for all corporations, analysts, investment banks and others who are interested in the theory of reasonable and efficient company or performance valuation.

Stage two, to be presented in chapter four, then embraces a specific investigation whether DCF and EVA, which basically focus on typical industrial companies are or could be applied in terms of valuing banks and what special requirements of the banking industry needs to be addressed. Therefore the author collected primary data by means of a questionnaire but also used some expertise opinions which were derived from current literature to sort out whether or not the findings of the questionnaire match with existing theories. Furthermore, the author carried out a simplified valuation of Deutsche Bank based primarily on annual report data to examine a special DCF technique derived from the questionnaire.

The author chose the questionnaire as a means of testing the research question above by indirect evidence collection, i.e. the questionnaire was designed to be sent online, made necessary by the sample being situated entirely in Germany.

1.2 Definition of sample

The questionnaire was answered by an analyst who works for the Asset Management division of Commerzbank, called Cominvest in Germany. There he is exclusively responsible for valuing European banks which might then - provided a promising valuation result - be picked up in one of Commerzbank’s funds for private as well as institutional investors which are run by in-house fund managers with whom the analyst is working.

The selection of the Commerzbank analyst was not undertaken at random. The author did a 3-month internship at Cominvest two years ago and in this context, worked closely together with the analyst. Due to the fact that the author did not receive any further questionnaires from other banks he has contacted (see 1.4), he had to rely on the know-how and experience of one single analyst. What impacts such a constellation might have on the outcome of the project is discussed in the limitations section (1.4) of this chapter.

1.3 Questionnaire design

The questionnaire was designed to allow a digital response, i.e. it was e-mailed and hence, did not have to be printed out and sent away which indeed could be seen as an advantage.

In order to reduce the amount of inappropriate answers and to increase the ease of completion for the respondent the author used primarily closed questions. However, a limited number of open questions were included in order to identify specific issues associated with bank valuation which mainly derive from personal experience and therefore could not be covered in a closed question. Moreover open questions were used in combination with closed ones to put emphasis on some points, e.g. the respondent had to classify the practicability of DCF for valuing banks (closed) but then explain why he chose that answer. This technique aimed to provide the author with in-depth understanding of the practice.

1.4 Limitations

Limitations were encountered at differing levels of this project. Due to the sensitive nature of the topic the author was not able to receive real cases from investment banks or consultancies concerning DCF or EVA valuation. This was supported by the argument that such information is classified as a trade secret which is prohibited to be published. Hence, all calculation examples are based exclusively on secondary data which indeed can be seen as a limitation.

An additional limitation derives from the fact that the author was reliant on the information provided in the questionnaire he received from the Commerzbank analyst. Although considerable efforts were undertaken to involve further analysts of partner agencies of the Commerzbank, such as UBS, Goldmann Sachs or SSB no more questionnaires were returned. The author learned that the analysts had been very busy due to current reporting activities. If the deadline restraints of the project had been extended the author could have increased the extent of the research to include more analysts in a wider geographical sample. However, since this is not possible the author was dependent on the expertise and experience of just one analyst. Consequently, the conclusion drawn from the primary research might not be valid for the entire bank valuation segment, since the practices of the Cominvest analyst could vary from other companies undertaking different approaches. Therefore the results should be viewed with caution.

A thorough discussion and analysis of the primary data in relation to the existing theory written on DCF and EVA (chapter two and three) will be presented in chapter four.

Chapter 2 The Discounted Cash Flow (DCF) Approach

Over the last ten to fifteen years the concepts and underlying models in the field of company valuation have undergone significant changes. Nowadays valuation techniques seek not only to integrate rather subjective company based figures such as earnings or profit but to involve more macro-oriented data which derives directly from the capital market. In essence, the expectations of the capital providers and the risk undertaken should be adequately considered in the valuation process. Therefore a company only generates a profit or surplus when the expectations of the market which provides the necessary capital are met. These ideas have been the subject of many discussions in the field of corporate finance. As a result a great number of management consultancies and investment banks employ one particular method when it comes to company valuation - the Discounted Cash Flow (DCF) model. According to Nowak (2000:23) this approach is characterized by a higher level of objectiveness. It uses cash flow figures, so the argument goes, instead of accounting numbers (e.g. net deposits) that do not focus on legal frameworks such as accounting rules and concepts (depreciation policies or estimation of bad debts) which give management sufficient space to shape the earning figures in a self interested way.

Cash flow can be seen as an indicator of the company’s present and future level of internal financing power. According to Dahmen, Jacobi and Roßbach (2001:165- 166) this power reflects the organic liquidity of a company during an accounting period and is measured by means of the cash flows.

Throughout this chapter a detailed analysis of the DCF concept, i.e. its requirements, definitions of cash flows, different techniques and estimation of adequate discount rates will be undertaken. However, before the author illustrates the essentials of the DCF valuation, it is necessary to address the shareholder value approach which provides a conceptual basis for this valuation approach.

2.1 The Shareholder Value Concept

The SHV concept has been developed to a widely accepted managerial tool within the last few years. Originally the term was based on American management literature. In 1986 Alfred Rappaport discussed the subject for the first time in his book “Creating Shareholder Value: The New Standard for Business Performance”.

The shareholders own the company and elect the board of directors, which should then represent their interests. Consequently, one can conclude that the purpose of the company is to maximise shareholder wealth respectively shareholder value, i.e. the current market value of equity (Rappaport 1998). Hence, the SHV concept demands management to focus its activities on the expectations of the capital market.

The factors, which are essential for the successful development of the shareholder value concept can be summarized briefly. The very active market of corporate control of the eighties followed by the inability of the new management teams to effectively lead the companies constitutes the beginning of this development (Martin and Petty 2000:12-13). The conception of equity option models as an integral part of executive remuneration, however, influenced the shareholder value concept to gain ground. The promising development of the german and american stock markets of the nineties, encouraging more and more people to own shares also made a substantial contribution to drive the shareholder value concept ahead (Schmidt 1996). The pension reform in Germany, to provide an example from the author’s country of origin, intended that people should gain additional private income by investing in stocks and mutual funds in particular.

Having illustrated some of the essential aspects inherent in the SHV concept, a more distinct relationship between SHV and DCF should be developed. The SHV, as mentioned earlier, represents the present market value of equity which management seeks to maximise in the long-term. It is calculated by the following formula:

Exhibit 2.1 The Shareholder Value Concept

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Source: Manz and Dahmen (1999:10)

The present market value of equity, i.e. the SHV is computed by discounting forecasted cash flow streams to equity investors by an appropriate discount rate reflecting the risk undertaken. A discussion of the factors involved in calculating and defining appropriate discount rates will be presented in section 2.6.

According to Nowak (2000:24) the relationship between SHV and DCF can be expressed as follows: The DCF led to the practical development of the SHV approach since it provides the necessary calculation technique in order to determine SHV. Therefore, the expressions DCF and SHV may not be used in a synonymous way. The former describes the technique the latter the objective variable which both have to be strictly separated. Coming back to the expected future cash flow streams, which represent the source of the company’s further success, the following section of this chapter will provide a detailed explanation of this important figure and will then investigate the distinct techniques of the DCF valuation model.

2.2 Calculating Cash Flows

Originally, the index of the “classical cash flow” has been created by security analysts at the beginning of 1950 in the USA (Rappaport 1986) in order to analyse shares. It represents a payment flow oriented concept that describes a cash operating surplus of a certain period of time. In essence, this figure constitutes the financing power which derives from the inside of the company and thus can be used in order to undertake investments, to pay off debts, to pay out dividends or to maintain the liquidity critical for the operating business (Manz and Dahmen 1998:8). Generally, cash flow can either be calculated in a direct or indirect way. The subsequent two sections briefly consider both ways which lead to an identical cash flow figure, on the condition of a consistent calculation.

2.2.1 The Direct Cash Flow Calculation

The crucial aspect of this method is that all net income affecting disbursements will be deducted from the net income affecting deposits of one financial year in order to calculate the gross cash flow:

Exhibit 2.2 Direct Cash Flow method

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2.2.2 The Indirect Cash Flow Calculation

This technique describes a more complex way to calculate cash flow. According to Jung (2000) it starts with net income and than adds back depreciation, amortization and changes in long-term provisions. In addition, it makes adjustments for revenues and expenses that relate to investing or financing transactions (see Exhibit 2.3). One final step which has to be undertaken is to adjust for changes in working capital accounts. According to Shrieves and Wachowicz (2001) this can be explained as: subtracting changes in current assets (subtract increases, add decreases) and adding changes in current liabilities (add increases, subtract decreases).

Exhibit 2.3 Indirect Cash Flow method

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Source: Own interpretation of Dahmen (1998)

2.3 Cash Flow versus Free Cash Flow

The classical cash flow figure presented so far does not involve tax payments and distribution of generated cash streams to either equity or debt holders. In addition, expenditures on plant replacements and extension investments also remain unconsidered, which constitute a serious issue, since they contribute, as a company’s source of income, to the long-term continuation of the business. Therefore, the need emerges to adjust this figure in order to receive a “Free Cash Flow” (FCF) which is consistent with the definition of the SHV concept discussed earlier and thus can be used in a discounted cash flow calculation. Copeland, Koller and Murrin (2000:167) describe FCF as a company’s true operating cash flow. FCF, so the argument goes, is used by a company’s management to service primarily the needs of the shareholders, since it reflects the financial means the shareholders are seeking - the dividend payments. Generally speaking, FCF indicates the surplus cash which is freely distributable to either debt or equity holders. In their book “Valuation” (2000) they use the following method to compute FCF:

Exhibit 2.4 Free Cash Flow calculation

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Source: Copeland, Koller and Murrin (2000:135)

Having defined a cash flow figure which is consistent with the SHV approach the next section will draw attention to the necessary instrument to calculate the market value of equity - the Discounted Cash Flow valuation concept.

2.4 Fundamentals of DCF valuation

The DCF valuation can be described as a mathematical concept which seeks to estimate the present value of an entity or the whole company by discounting expected future free cash flow streams by an appropriate discount rate reflecting the expectations of the market. It has been introduced by Nobel Prize winners Merton Miller and Franco Modigliani in 1961 (Brealey and Myers 2000).

With regard to the increasing influence of private as well as institutional investors, mentioned earlier, if could be stated that company valuation must seek to compute a fair value which mirrors the expectations of the capital market, in particular those of the shareholders as reliably as possible. The DCF method indeed emphasizes this issue by using risk models, such as the CAPM (see 2.6.1.1) which are focused on the capital market, and hence allow a more objective determination of the discount rate. In this context Serfling and Pape (1996:58) have highlighted the objective of the DCF approach in a very precise way: “The DCF approach aims at the adequate determination of the market value of equity”.

Basically, several different techniques of DCF can be identified. However, in case of identical assumptions concerning the input factors, they should all finally provide the same result. Therefore, the following sections will examine only the two most important ones - the Entity and the Equity approach.

2.5 Techniques of DCF

2.5.1 The Entity Model

This model of DCF valuation, as the name already suggests valuates the company as a whole by discounting free cash flow streams, which addresses both equity and debt capital providers. Just to mention that briefly most authors use the term above, however, some, for example Copeland, Koller and Murrin (2000) describe it as ‘Enterprise DCF Model’ or Damodaran (2001) as ‘Firm Valuation’.

Before moving into a more detailed examination, the basic ideas of this approach are well illustrated by referring to the work of Rappaport (1998): The total economic value (corporate value) of an entity such as a company or business unit is the sum of the values of its debt and its equity. Rappaport called the equity portion shareholder value. With this in mind the Entity approach calculates the corporate value first (Exhibit 2.5, Stage 1). Corporate value, in turn, consists of two basic components: the present value of FCF from operations during the forecast period, and the residual or continual value, which represents the present value of the business attributable to the period beyond the forecast period. The market value of equity is subsequently derived by discounting the FCF streams by the cost of capital and then deducting the market value of debt (Exhibit 2.5, Stage 2). In this case the discount rate must reflect the opportunity cost to all the capital providers weighted by their relative contribution to the company’s total capital (Copeland, Koller and Murrin 2000:134). This is called the Weighted Average Cost of Capital (WACC). A more detailed discussion of this figure is presented in section 2.6.3. The Entity approach can be summarized by the below stated formulas.

Exhibit 2.5 The Entity approach

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Source: Own interpretation of Dahmen and Oehlrich (2001)

This rather basic illustration of the Entity model does not cover more sophisticated aspects such as the determination of the forecast period, estimation of residual value, analysis of cash flow and value drivers or changes in capital structure and subsequent circularity problems associated with the WACC approach (see 2.6.3) since a discussion would go beyond the scope of this study. For a detailed analysis see Copeland (2000) or Rappaport (1998).

2.5.2 The Equity Model

According to Copeland, Koller and Murrin (2000:150) this DCF model is regarded as the simplest one in theory but is actually difficult to carry out in practice. Shrives and Wachowicz (2001) stated that this is due to the fact that the equity beta (for an explanation of the beta coefficient see 2.6.1.1) is quite sensitive to changes in capital structure. This study will not further investigate such specific aspects but will focus on the theoretical conception.

In contrast to the Entity approach the Equity approach computes the market value of equity in a direct way. According to Nowak (2000) the cash flow figure required for the calculation is no longer the FCF presented in Exhibit 2.4 but a free cash flow figure after interest payments to debt capital providers have been undertaken. Hence, the remaining amount exclusively aims at the shareholders. The calculation of the equity value is then relatively straightforward:

Exhibit 2.6 The Equity approach

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Source: Dahmen and Oehlrich (2001:26)

The figure FCFEKt as explained above is entirely addressed to the shareholders. Hence, the discount rate needs to be adjusted as well (Nowak 2000:29). In this case only the yield expectations of the equity providers will be reflected which can be calculated by using either the CAMP or the APM. A profound examination of these risk models will be undertaken in the subsequent sections.

2.6 The Price of Risk - Estimating appropriate Discount Rates

The DCF concepts presented so far, worked under the assumption of a given discount rate in order to make the future cash flow streams comparable to the present situation. The following sections will examine the underlying factors associated with an adequate and truly representative discount rate. According to Damodaran (2001) the most important principle to recognize when estimating a discount rate is that it must be consistent with the overall valuation approach and with the definition of the cash flow to be discounted. Consequently, as shown in the previous section discussing different DCF techniques the determination of three types of discount rates needs to be distinguished:

- The Cost of Equity (CoE)
- The Cost of Debt (CoD)
- The Weighted Average Cost of Capital, i.e. weighted average of equity and debt capital (WACC)

2.6.1 The Determination of the Cost of Equity

In general the CoE represents the rate of return that investors in a firm’s equity expect to make on their investments (Damodaran 2001). Thus, the determination is connected with the attitude of the investor and his demand for yield. It goes without saying that there exist a positive relation between expected yields and risk undertaken. Hence the more risky a company might be the higher the expected returns (CoE) will be.

There are several accepted risk and return models in finance (Appendix A).

However, due to the restricted scope of this work, the author has decided only to discuss the two most popular ones - The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Model (APM).

2.6.1.1 The Capital Asset Pricing Model (CAPM)

The CAPM was developed in the 1960s as a new capital market model by Sharpe, Lintner and Treynor (Ross 1976). It is based on the assumption of an efficient capital market (Paulo 2002). The bearing such a market has on the validity of CAPM and therefore on DCF and EVA which make use of it will be discussed in chapter 3.4.2. According to Copeland, Koller and Murrin (2000:214) it postulates that the opportunity cost of equity is equal to three factors: the return on risk-free securities plus the company’s systematic risk (beta) multiplied by the market price of risk (market risk premium). On the basis of this explanation the CoE can be calculated as follows:

Exhibit 2.7 The calculation of the CoE based on the CAPM

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Source: Copeland, Koller and Murrin (2000:215)

In the following the components required to carry out the CAPM approach will be examined in a more detailed way.

The Risk-free Rate

The risk-free rate can be determined in a relatively reliable manner. It is normally reflected in long term government treasury bonds. With reference to Johnson (1999:153) a proxy for the risk-free rate is easy to obtain because of the frequent and widespread publications of prices and yields of government securities. Copeland, Koller and Murrin (2000:215-216) suggest to use the rate for a ten year Treasury bond since this rate is both, less sensitive to the changes in inflation and it approximates the duration of the applied stock market portfolio, e.g. the S&P 500.

The Market Risk Premium and Systematic Risk (Beta)

The market risk premium measures the “extra return” that would be demanded by investors for shifting their money from a risk-less investment to an average-risk investment (Damodaran 2001:60). According to Rappaport (1998) it can be based on either historical data (most often employed technique) or on ex ante estimates that attempt to forecast the future. A further examination cannot be undertaken since it would go beyond the scope of this work. For an in-depth discussion the work of Damodaran (2001) or Johnson (1999) should be reviewed.

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