This article focuses on a high level approach to company valuation! My favorite method to value a company is the discounted cash flow approach (DCF).

It is calculated by estimating the total value of all future cash flows, and then discounting them (usually using Weighted Average Cost of Capital – WACC) to find a present value of that cash.

## Example

For this example, we’re going to assume that a company is an apple tree. How do we figure out how much it’s worth?

- We could see how much other apple trees are worth and compare our tree to similar trees. (Comparable Companies)
- We could see how much other orchards have purchased similar trees for. (Precedent Transactions)
- We could see how much the apples our trees will produce in the future and the wood that makes up the tree are worth if we discount the value back to today. (Discounted Cash Flow Analysis)

These are the same three ways that investment professionals value a company! Each valuation method has its pros and cons, so its best to use all three methods then compare the results from each. This way, if one method is way off, you can use the other two to help reel your assumptions in.

Comparable Companies and Precedent transactions are known as **Relative valuation**. This is because you are valuing your company relative to a different company’s valuation.

See the problem? No one knows exactly what any company is worth. So, when you are valuing a company based off another valuation, you are getting more and more removed from the original data.

Let’s focus on the more theoretically correct way to value a company – a Discounted Cash Flow (DCF) analysis

## DCF Analysis

Discounted cash flow analysis boils down to:

**Company value = Cash Flow / (Discount Rate – Cash flow Growth Rate)**

*Note Discount Rate > Cash flow growth rate*

*If the Discount rate and cash flow growth rate stay the same in perpetuity.

This article will run through each part of the equation and hopefully give some insight into why this is the correct way to provide an **Intrinsic Valuation**.

## Cash Flow

Cash flow is simple to understand, the real challenge comes from creating accurate estimates for cash flow in the future. In DCF analysis what we really care about in unlevered free cash flow.

In simple terms, **unlevered free cash flow is how much recurring cash flow a business generates before it has paid ANY investors. **For this reason, we don’t subtract out interest expense as that expense is related to debt investors.

For reference, Unlevered FCF can be calculated with the following equation:

**Unlevered FCF = EBIT (Earnings before Interest & Taxes) – Taxes + Depreciation & Amortization – Capital Expenditures and factoring in changes in Working Capital.**

Normally, you would project out Unlevered FCF for 5 to 10 years and use the terminal year to calculate the value captured outside of your projections.

## Discount Rate

The best way to think of a discount rate is as an opportunity cost. An opportunity cost is something that you give up to pursue a different route.

For example, an opportunity cost of going on that spring break trip to Florida is giving up the money you’d make staying at home and working.

So, the real economic cost of going to Florida would be whatever the trip costs + whatever you could have made staying at home.

In this context, the opportunity cost is the rate of return you could receive by investing in a company with a **similar risk profile**. This is calculated by a metric called Weighted Average Cost of Capital (WACC).

For simple purposes we’ll assume this company is funded with just equity and debt. For how to calculate the cost of equity using CAPM refer to my article on cost of equity here!

The cost of debt is calculated by seeing what the company would pay if it issued more debt.

**WACC = Cost of Equity * % Equity + Cost of Debt (1 – Tax Rate) * % Debt**

What WACC boils down to is the companies expected return if you were to proportionally invest in the same debt and equity percentages that make up the company as a whole! We decrease the cost of debt by the tax shield of interest expense here to reflect the benefits of debt.

## Growth Rate

The growth rate is perhaps the most powerful part of the valuation formula, and unfortunately it is also the hardest to accurately project. This is the rate that the company will grow at in perpetuity!

For this reason, the growth rate should be lower than GDP growth. If we chose a higher growth rate, our humble apple tree would eventually surpass the GDP!

This is why we project out Unlevered FCF for 5 to 10 years, so we can show periods of higher growth without over valuing our company. In most developed markets a terminal growth rate of 1-3% is fine.

## Value A Company

For the first 5 to 10 years of cash flow you would just individually discount these values back to present value.

Current Value of Y_{x }= Cash Flow Y_{x} / (Discount Rate Y_{x }) ^{x}

The reason I subscripted all these years is because these values can **all change over the years**. This makes the valuation more complex than just the original formula.

Once you’ve calculated the present value of the first 5 to 10 years of your projections, it is time to calculate their value for the time frame outside of the projections. Now we’ll loop back to our original equation.

This equation will effectively tell us how much the cash flows will be worth **forever. **But remember, due to the time value of money, cash flow from 10,000 years from now is worth almost nothing.

**Company value = Cash Flow / (Discount Rate – Cash flow Growth Rate)**

## Conclusion

Now we can just sum the present value of all our cash flows, and that is how much our company is worth! The main takeaway from DCF analysis is your implied value is **only as accurate as the assumptions you put in.**

Much like anything in life, your product is only as good as the ingredients. So, if you accurately project your assumptions, you’ll get an accurate valuation. If you use a bunch of random numbers, you’ll just get a random valuation!

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