According to professor Damodaran, the intrinsic valuation of a business is the “expected cash flows on the asset over its lifetime and the uncertainty about receiving those cash flows.”
The professor calls this, “discounted cash flow valuation.” What’s something that cannot be analyzed with this model? Things that don’t generate cash flows – ie. a painting, a good book, anything whose value is depending on the beholder. There are two ways to come up with a discounted cash flow valuation:
- By looking at the expected cash flows and adjusting for risk across all possible scenarios and summing it up. All scenarios means all possible values for risk that the company might face depending on different scenarios. In other words, you are taking the cash flows and adjusting for different risks.
- The other scenario is by having a fixed risk and adjusting for cash flows. That is, take different cash flows across time and use the same risk premium.
These can be expressed as such:
Value of an asset = ∑ E (CFn) / (1 + r )n
Value of an asset = ∑ CE (CFn) / (1 + rf ) n
Where E * CF is Expected Cash Flow, r is Risk, CE is Certainty Equivalent Cash Flow and rf is Risk Free Rate.
This has a lot of common sense. What is the value of a business that never returns a positive cash flow? zero. Likewise, the value of a business that returns a large cash flow, and conserves a small amount of risk, is likely to be very valuable. A company like Apple comes to mind.
Now, how can we go about valuing companies based on these principles? We can look at their financial statements, specifically at their assets and liabilities.
Assets include investments that the company has already made, and assets that the company hasn’t made yet (this represents the expected growth potential that the company will have in the future). Companies in different stages of growth will have differing levels of asset classes. For instance, P&G will have a lot of investments made, but perhaps won’t have as much growth potential as say, Tesla.
Liabilities represent how a business must fund its operations. It can do it by using its own money (equity), or taking a loan (debt).
Here’s where we face a fork in the road. There are two ways to value a business, either by valuing their equity, or by valuing the entire business. Simply put, equity valuation is concerned with the cash flow that is returned to its investors. In public markets, this would be dividends (though the professor shows that you can measure a company’s equity value without dividends via their potential, future dividend).
Valuing the entire business takes a broader view by looking at the equity value and the liability value for its lenders, taking them together and calling it, Cost of Capital. You then discount the cash flows to the business at the Cost of Capital and get the value of the entire business.
So we conclude with two ways to value a company. We can value directly the equity of the company and adjusting it for risk, or get the value of the company via the cost of capital and subtracting debt.