Supply and Demand and the Value Equatio
Mercury Capital Analytics
Corporate Finance White Paper
Supply and Demand and the Firm
Value Equation
There are a variety of methods for determining a valuation of a business, but, as with any pecuniary value, the price the market is willing to pay for business enterprises is determined by the laws of Supply and Demand. Inevitably one important method of establishing the value of a business will be based on a discounted cash flow analysis.
This takes a projected earnings stream and uses a discount rate to determine net present value. Using the Supply and Demand metaphor, it is innovation in product, operational efficiencies, and marketing strategies that drive an earnings stream that stands out in its growth and margins. This is the Supply Side of the equation. The more innovative the model and strategy, the better the earnings stream, and the more the Supply Curve shifts to the left. The Demand Side of the equation is all about investors' confidence in management's ability to deliver the projected earnings stream. In other words, Demand is driven by the level of perceived risk which is reflected in the Discount Rate. The greater the confidence, the lower the discount rate, and the more the Demand Curve shifts out to the right. With the Supply Curve shifting leftward, and the Demand Curve shifting to the right, the valuation of the enterprise is driven up.
1
S’
S
Value 3
Value 2
D’
Value 1
This chart shows the effect of superior innovation in moving the Supply Curve to the left, thereby increasing Firm Value, and the further effect of superior financial execution in moving the Demand Curve to the right, thereby increasing Firm Value even more. D
There is a conceptual framework in corporate finance theory for minimizing the discount rate, thereby shifting the Demand Curve outward. It’s called the Cost of
Capital. But as a practical tool for assisting management in accomplishing this, Cost of
Capital with essentially worthless. For a detailed discussion of
Corporate Finance White Paper
Supply and Demand and the Firm
Value Equation
There are a variety of methods for determining a valuation of a business, but, as with any pecuniary value, the price the market is willing to pay for business enterprises is determined by the laws of Supply and Demand. Inevitably one important method of establishing the value of a business will be based on a discounted cash flow analysis.
This takes a projected earnings stream and uses a discount rate to determine net present value. Using the Supply and Demand metaphor, it is innovation in product, operational efficiencies, and marketing strategies that drive an earnings stream that stands out in its growth and margins. This is the Supply Side of the equation. The more innovative the model and strategy, the better the earnings stream, and the more the Supply Curve shifts to the left. The Demand Side of the equation is all about investors' confidence in management's ability to deliver the projected earnings stream. In other words, Demand is driven by the level of perceived risk which is reflected in the Discount Rate. The greater the confidence, the lower the discount rate, and the more the Demand Curve shifts out to the right. With the Supply Curve shifting leftward, and the Demand Curve shifting to the right, the valuation of the enterprise is driven up.
1
S’
S
Value 3
Value 2
D’
Value 1
This chart shows the effect of superior innovation in moving the Supply Curve to the left, thereby increasing Firm Value, and the further effect of superior financial execution in moving the Demand Curve to the right, thereby increasing Firm Value even more. D
There is a conceptual framework in corporate finance theory for minimizing the discount rate, thereby shifting the Demand Curve outward. It’s called the Cost of
Capital. But as a practical tool for assisting management in accomplishing this, Cost of
Capital with essentially worthless. For a detailed discussion of