The value of a business is equal to the amount of cash you can take out of it for the rest of its life discounted to the present.
Learning how to value a company is just like riding a bike. It takes time, but with enough practice, it becomes almost effortless and a lot of fun. We’ll start with the basics, then perform a quick back-of-the-envelope valuation of Apple so you can see what valuation is about at a high level, and then we’ll dig into the details.
This guide is a passion project for me, which means I’m updating it regularly and if you have any questions or find anything that could be improved, please contact me so I can update it. Let’s get started.
The value of a business is equal to the amount of cash you can take out of it for the rest of its life discounted to the present. The discounted component of this definition can be confusing at first. Let’s look at a quick example.
If you had a bank account with a balance of $100, how much is it worth? That’s easy. It’s worth $100. The current cash flow can be easily valued at $100 as there’s no risk because we can withdraw the money right now.
What about if you had a second bank account with a balance of $100, but you couldn’t withdraw the money for a year? You wouldn’t pay $100 for the cash in the bank account because you have to wait a year to use the money. With the first bank account containing $100, you could buy a fancy new gadget today or invest the money so you’ll have more in a year. Keeping this in mind, bank account one is more valuable than bank account two, which is the same as stating money today is more valuable than money tomorrow. Making cash you receive tomorrow worth less than that same cash flow you receive today is called discounting.
Another way to look at discounting is to think of it as the interest rate you would charge to lend your money to someone else. When a bank gives you money, they want to make money for lending you their money, and they also need to add a little extra on top just in case you don’t pay them back. The total rate when you factor in the money they want to make and the risk of loss is called the discount rate to the bank, which is the same as the interest rate charged to you the borrower. To put discounting into numbers, $100 in one year from now at a 10% discount rate would be worth roughly $90.90 today. $100 / (1 + 10%) = $90.90.
To put compounding into numbers, $90.90 grown at an interest rate of 10% would be $90.90 * (1 +10%) = 100.
Discounting is taking money from the future and bringing it to the present, and compounding is bringing money in the present and taking it into the future. Discounting and compounding are two sides of the same coin.
With a conceptual understanding of discounting, we can now revisit the intrinsic value definition: The value of a business is equal to the amount of cash you can take out of it for the rest of its life discounted to the present.
This definition shows us that in valuation cash is king. We can estimate the intrinsic value for any business or asset that has cash flows. This definition also implies that if an asset does not provide cash flows, it cannot be valued; instead, it can only be priced relative to what others have paid for it in the past.
I’m going to repeat that as there’s a lot of confusion around this point. Only assets that produce cash can be valued. If you’re deciding what to pay for an asset based on what others have paid, you’re pricing the asset – you’re not valuing it.
At a high level, valuing a cash-producing asset can follow a four-step process by looking at the past, present and future cash flows and the risk of those cash flows:
- The current free cash flows
- The future free cash flows
- The risk of the free cash flows
- The previous free cash flows
I am explicitly stating free cash flows and not just cash flows because a business isn’t worth anything as an ongoing business if it requires all of the cash to be plowed back into the company to keep its doors open. We care about money left over that the company can put into our pockets. Now with that out of the way, let’s do a back-of-the-envelope valuation of Apple by opening Apple’s financial statements on Yahoo! Finance.
Step 1: The Current Cash Flows
Apple had $48.3 billion in net income for the year ending 9/30/2017. Apple also had $12.5 billion in capital expenditures and $10 billion in depreciation, giving us a reinvestment of $2.5 billion. Subtracting the cash needed to keep growing the business from the extra cash that the business is generating for the owners gives us a rough estimate of $45.8 billion. $48.3 - $12.5 + $10.0 = $45.8
Step 2: The Future Cash Flows
Apple is a massive mature company, so let’s assume it can grow free cash flow by 3% annually. At the moment, don’t worry about how I came up with this value. We’ll discuss how to determine growth rates at length in the future. We’ll also assume Apple is sold at the end of year 10 for 15 times free cash flow.
Step 3: The Risk of the Cash Flows
Let’s discount each year’s cash flows and the sale price at 10% as that’s the return we want to make. A 10% discount rate gives us a present value of $680.69 for Apple’s free cash flow.
Step 4: The Previous Cash Flows
Apple’s existing bank balance from prior year cash flows have not been taken into account. Let’s add Apple’s whopping $268 billion in cash to our valuation. Adding the cash balance to the discounted future money we expect Apple to generate for its owners gives us a $948 billion valuation, or $189.74 per share when dividing by the 5 billion shares outstanding.
Here are the cash flows discounted in table form with the numbers in billions:
|Discounted Cash Flows||$680.69|
|Total Discounted Value||$948.69|
|Value per Share||$189.74|
Today’s price is $181.58, and according to our five-minute valuation, Apple is 4% undervalued. Apple is underpriced by 4% based on our valuation. Would I buy Apple becomes of this? No way! If Apple’s growth was 1% instead of 3%, and the sale at the end of the year was 10 times free cash flow instead of 15, the stock would be overpriced by 20%!
We’ll get more advanced in the future by valuing the cash flows before debt payments, applying a more rigorous discount rate, and projecting out cash instead of applying a multiple, but the fundamental idea stays the same even though the methods get more complex: The value of a business is equal to the sum of its discounted free cash flows. As we dig into the details, it’s essential to keep the big picture in mind.
So what’s next?
Before you dig into the details on how to value a business, you may need to brush up on some prerequisites. If so, I’ve got you covered:
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