The valuation of firms and their profitability is a central topic in finance, accounting and economics. The literature has evolved from a focus on dividends as a valuation attribute to cash flows and more recently to book value and earnings. Our paper continues the evolution toward expressing value as a function of attributes that pertain directly to the value-creation process. Specifically, we formulate a model that expresses a firm's intrinsic value as a function of its investment history and its future investment opportunities.
The basic building block of our model is what we term the investment kernel. For a given level of current investment, it describes the stream of expected future cash flows. Firms are assumed to choose their level of investment optimally in each period up to the point where the net-present value of the last dollar invested is zero.
To capture the notion of a firms' life cycle (or the life cycle of its products), we allow for the investment kernel to vary over time, possibly in a non-monotonic fashion. Investment opportunity sets are, of course, unobservable in practice because accounting data do not reveal the present value of expected cash flows from current investments. However, firms report their current investment spending, for example, in the form of capital expenditures, R&D and advertising. Furthermore, the earnings and cash flows reported in each period provide information about the economic profitability of past investments. By restricting attention to a parametric class of investment kernels, we can use the time-series of firm-specific accounting information to estimate a particular firm's investment kernel. This allows us to recover the mapping from investment to payoffs and thereby make inferences about intrinsic value, profitability and the firm's effective cost of capital.
Hiemann, Moritz, Maureen McNichols, and Stefan Reichelstein. "Investment Kernels, Accounting Data and Intrinsic Value" Columbia Business School, 2015.
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