The best-kept secret of financial professionals is that it’s actually pretty easy to value a company, that is, decide how much you should be willing to pay for the business or its shares. My goal is to automate this process using machine learning algorithms to select the appropriate data and apply the formulas in the correct manner. This level of sophistication is still a few months (years?) away, at least by my skillset. For now, we’re going to cover the basics of project valuation via the discounted cash flow (DCF) methodology. Later on, we’ll see if we can get a computer to do the calculations for us.
Note: I’ll be using the terms company and project interchangeably here. However, for companies in more than one industry or market segment, you’ll need to use multiple discount rates because the Beta (systematic risk of the segment divided by the market risk) will vary depending on the industry.
You can probably find a lot of the information that I’m about to disclose (or all of it) in an introductory finance textbook or even from a free resource like Investopedia. That’s fine. Lots of people do not choose to read textbooks or financial-wiki sites in their free time, so I’m going to go over the basics here if you’re interested in the subject, but not quite interested enough to open a book.
Here we go. Are you ready?
All that is needed to value a company is:
1. Some revenue projections,
2. Some cost projections,
3. An appropriate discount rate (or cost of capital) for the company
That’s it!
Obviously, these things can be easy or very difficult to come by depending on several factors including the type of company (or project), the stability of the market, and the quality of the information available about the business.
Let’s assume //quite a big assumption, but hey, that’s what we’re going to do right now// that you’re able to come up with some reasonable revenue and cost projections for the business that you want to value and that you’re able to calculate an appropriate WACC (Weighted Average Cost of Capital) or discount rate.
Then what do you do?
Basically, you take the company’s projected revenue over a given period (let’s say every year for 5 years), subtract the cash costs on the business in each year and you’ve got the company’s Free Cash Flows (we’re skipping a few steps here like subtracting taxes, adding back depreciation, and subtrac
ting Capital Expenditures (CapEx) and changes in Net Working Capital, but we’ll save those for later).
Here’s an example of a company with some projected revenue and some projected costs going out 5 years:
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Revenue | $20,000 | $20,000 | $20,000 | $20,000 | $20,000 | |
| Costs | ($50,000) | ($5,000) | ($5,000) | ($5,000) | ($5,000) | ($5,000) |
| Cash Flows | ($50,000) | $15,000 | $15,000 | $15,000 | $15,000 | $15,000 |
Next, we take the free cash flows that we calculated above, and we discount each of them by an appropriate ‘discount factor’ that we calculate using our discount rate.
All of my finance professors are about to roll over in their beds right now (they’re not dead), but let’s say the discount rate that we found for the company is 10%. Here’s what we end up with for the discount factor over the 5-year period.
| Year | 0 | 1 | 2 | 3 | 4 | 5 | ||||||
| Revenue | $20,000 | $20,000 | $20,000 | $20,000 | $20,000 | |||||||
| Costs | ($50,000) | ($5,000) | ($5,000) | ($5,000) | ($5,000) | ($5,000) | ||||||
| Cash Flows | ($50,000) | $15,000 | $15,000 | $15,000 | $15,000 | $15,000 | ||||||
| Discount Factor | 1.00 | 0.91 | 0.83 | 0.75 | 0.68 | 0.62 | ||||||
| Discount Rate | 10% | |||||||||||
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Now we just multiply our free cash flows by the discount factor for each year to get the present value (PV) of the future cash flows. Once we have the PV of the cash flows, we can add them all together to find out what the project is worth to us, also known as the project’s NPV or Net Present Value.
| Year | 0 | 1 | 2 | 3 | 4 | 5 | ||||||
| Revenue | $20,000 | $20,000 | $20,000 | $20,000 | $20,000 | |||||||
| Costs | ($50,000) | ($5,000) | ($5,000) | ($5,000) | ($5,000) | ($5,000) | ||||||
| Cash Flows | ($50,000) | $15,000 | $15,000 | $15,000 | $15,000 | $15,000 | ||||||
| Discount Factor | 1.00 | 0.91 | 0.83 | 0.75 | 0.68 | 0.62 | ||||||
| PV Cash Flows | ($50,000) | $13,636 | $12,397 | $11,270 | $10,245 | $9,314 | ||||||
| Project NPV | $6,862 | |||||||||||
| Discount Rate | 10% | |||||||||||
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If you want a primer on what present value means, and what the time-value of money represents, here’s a good video on it from Khan Academy:
That’s it! We’ve valued a business. We now know that if this company was only going to operate for five years, and then cease to exist, that it would be worth about $6,800 to us in our pocket today.
In general, we accept projects that have a positive NPV and reject projects that have a negative NPV. I’ll cover the reasons for this in another post down the line. For now, at least, we are able to value a company given only its revenue, costs, and an appropriate discount rate. Things are going to get a lot more complicated from here so enjoy the simplicity while it lasts.