Valuation — McKinsey (Koller et al.): COMPLETE

Valuation: Measuring and Managing the Value of Companies has been called the bible of consulting valuation, and rightly so — since its first edition in 1990 the book has defined how McKinsey, strategy consultants and, to a large extent, the entire institutional valuation tradition think. The fundamental thesis of Koller, Goedhart and Wessels is radical in its simplicity: the value of a business is the present value of the free cash flows it will generate, discounted at a cost of capital that reflects the risk.

In plain language: the value does not sit in the balance sheet, not in the quarterly report, not in the valuation multiple — the value sits in the future cash the business can pay out to its capital providers without harming itself.

Enterprise value (EV) is the book's central measuring point: the value of the entire business regardless of how it is financed. The formula reads EV = the market capitalization of the stocks + interest-bearing debt − liquid assets. Worked example: a company with market capitalization of 700 mn, interest-bearing debt of 350 mn and 50 mn in liquid assets has EV = 700 + 350 − 50 = 1 000 mn. Why are liquid assets subtracted? Because the business does not need them — they can be lifted out without touching a single cash flow.

Valuing at the EV level compares companies with different liabilities and debt loads on equal terms: the business itself. This is why McKinsey consistently works with FCFF (free cash flow to the firm, that is, before interest) and WACC — cash flow and discount rate must measure the same thing.

The DCF mechanics: value = Σ FCF_t / (1 + WACC)^t + TV / (1 + WACC)^T, where FCF_t is free cash flow in year t, and TV is the terminal value after the forecast period T. A minimal worked example: a company with FCF of 100 mn in one year, WACC of 10 percent and nothing more gives a present value of 100 / 1,10 = 90,9 mn. If the cash flow continues forever, EV = FCF / WACC = 100 / 0,10 = 1 000 mn.

Note the sensitivity: if WACC rises to 12 percent the perpetuity value falls to 833 mn — 17 percent of the company's value vanished on two percentage points. This is not a bug but the book's most important pedagogy: valuation is an exercise in humility before assumptions.

Always distinguish price from value. The price is set by the market's voices — supply, demand, sentiment, index flows. Value is weighed out by future cash flows. The book's practical stance is that the market on average is surprisingly good at pricing expectations (a theme we return to in the empirical chapter), but that individual companies and entire sectors can at times trade far from reasonable cash flow assumptions.

The valuer's job is not to divine the course of the share price over the next quarter — it is to state which assumptions are baked into today's price and judge whether they are reasonable. That is also exactly what makes AKM1's approach possible: compare the market's implicit expectations against your own.

The EV bridge is valuation's last mile: EV − net debt + non-operating holdings = value of the equity after liabilities and other claims. In full: equity value = EV − interest-bearing debt + liquid assets + the value of subsidiaries not wholly owned + any under-/overfunded pension and other non-operating assets, minus minority interest. Worked example: EV 1 000 mn, interest-bearing debt 350 mn, liquid assets 50 mn, minority interest 30 mn, unlisted holdings at intrinsic value 60 mn.

Equity value = 1 000 − 350 + 50 − 30 + 60 = 730 mn. Spread over 100 mn stocks that is 7,30 kronor per stock. Every post in the bridge is a potential analysis in itself: a cash box that will never come home to the shareholder is worth less than its booked amount.

This is where AKM1's V10 debt-to-equity ratio connects at full force. Two companies with identical businesses and identical EV of 1 000 mn can have entirely different equity values: company A with net debt of 200 mn gives 800 mn to the shareholders, company B with net debt of 600 mn gives 400 mn. Same machine, half the stock. This is also the two faces of leverage in DCF world: debt magnifies the return on equity when things go well and crushes it when the spread between ROIC and WACC turns negative.

The McKinsey model keeps these effects apart by design — value the business with FCFF/WACC first, the capital structure afterwards. Thereby even the debt-to-equity ratio becomes a question of value distribution rather than value creation in itself.

Two common bridging errors. The first: mixing the enterprise and equity levels — putting an EV valuation multiple on equity, or discounting FCFF with the cost of equity. Numbers and value become systematically wrong. The second: forgetting growing debt liabilities in companies with a structural deficit. Worked example of the former: EV/EBITDA of 8x applied to EBITDA of 200 mn gives EV 1 600 mn — but if you lay the same 8x on pre-tax profit (150 mn) and call it equity value, you have removed the interest rate burden, tax and debt from the calculation in a single line.

Level discipline is the entire difference between a bridge and a guess: FCFF and EV belong together, FCFE and equity value belong together.