Tom Nash
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Mastering Valuations (Without Losing Your Mind)
🕑 Added 2024-10-05 16:33:44 +0000 UTCValuation is a fancy word for figuring out what something is worth.
Whether you’re looking at a company’s stock, real estate, or the old comic books collecting dust in your attic, understanding value is key.
In this guide, we're going to break down the basics of valuation, keep it simple, and maybe even throw in a joke or two (finance can be fun, I promise folks).
The Basics
The most common way people figure out what a company is worth is through a method called the Discounted Cash Flow (DCF) model.
Think of it like this: you expect a company to make some money in the future, right? so, you want to know what that future money is worth today.
The DCF helps you do that.
Here’s how it works:
Free Cash Flow (FCF): This is the money a company has left after paying for things like new buildings or equipment. It’s the money the company can actually use to grow or pay out to shareholders. We calculate the estimated FCF of a company for the next 5 years into the future.
Discount Rate: This is where it gets a bit trickier. The discount rate is like the interest rate used to shrink those future cash flows to what they’re worth today. The higher the risk, the higher the discount rate. If the company is as unpredictable as grandpa, you’ll want a high discount rate, and that means the future FCF amounts will be worth less today.
Risk
Risk is everywhere in finance.
How much risk you’re willing to take affects everything about valuation. The higher the risk (like investing in a startup), the more cautious you need to be. makes sense right?
There are different types of risks:
Business Risk: The risk that the business you’re looking at isn’t as stable as it seems.
Financial Risk: If a company borrows a lot of money, it has to make sure it can pay it back. More debt equals more risk.
Geo Risk: If a company operates in countries with unstable economies or political systems, the risk goes up.
Growth
You’ve figured out the short term value, but what about the long term?
To value a company, you also need to think about the future. This happens in two stages:
High Growth Phase: most companies grow quickly at first. For the first 5 years we may use 20 or 30 percent annual growth for certain companies.
Terminal Value: Eventually, though, things slow down. This is the company’s value once it’s settled into a more stable, long-term growth rate. Here we will use 4% annual growth rate into the far future of the company.
Building Your Own DCF
Now, let’s break down how you can build your own Discounted Cash Flow (DCF) model.
Don't worry if it sounds a bit intimidating.
Step 1: Forecast Free Cash Flow (FCF)
This is the first big piece of the puzzle.
How to Calculate It:
here's the concept -
Start with Revenue (the money a company makes from selling its products or services).
Subtract Operating Costs (salaries, rent, and so on) to get Operating Income.
Subtract Taxes (because the government always wants its share).
Add back Depreciation and Amortization (these are non-cash expenses).
Subtract Capital Expenditures (money spent on buying new assets).
Boom: you’ve got Free Cash Flow.
You’ll want to do this for the next 5 years.
Step 2: Choose a Discount Rate
Now comes the fun part (yes, finance fun exists!).
The discount rate is used to figure out how much those future cash flows are worth today. Why? Because $100 today is worth more than $100 in 10 years, blame inflation, interest rates, and the fact that you could invest it today and make more money.
What Discount Rate to Use? Usually, you’ll use the Weighted Average Cost of Capital (WACC). This is a mix of the cost of the company’s debt and equity. Essentially, it’s the return investors expect to make from the company, considering the risk they’re taking.
As an academy member you can get access to my complete module on how to calculate WACC for any stock easily. Go to discord and look from Academy/lectures section for our ROIC Academy lectures archive.
Step 3: Discount Future Cash Flows
Now that you’ve got your future Free Cash Flows and your discount rate, it’s time to do some math.
For each year, you’ll divide the Free Cash Flow by (1 + Discount Rate) raised to the power of the year number (Year 1, Year 2, etc.). This formula shrinks the future cash flows back to what they’re worth in today's dollars.
It looks like this:
Discounted FCF=FCF(1+r)t\text{Discounted FCF} = \frac{\text{FCF}}{(1 + r)^t}Discounted FCF=(1+r)tFCF
FCF = Free Cash Flow for the year
r = Discount Rate
t = Year number (1, 2, 3… you get the idea)
Example: If a company expects $100 in FCF next year and your discount rate is 10%, then the value of that $100 today is:
100(1+0.10)1=90.91\frac{100}{(1 + 0.10)^1} = 90.91(1+0.10)1100=90.91
Keep doing this for all the years you’ve forecasted.
Step 4: Calculate the Terminal Value
Most companies don’t just stop making money after 5 years (hopefully). To account for all the cash flows the company will make after your forecast period, you calculate something called the Terminal Value.
This represents the company’s value at the end of your forecast and assumes it’ll keep growing at a constant rate forever (or at least for a really long time).
Here’s a tip: Don’t get crazy with the growth rate here. Use 4%.
Step 5: Discount the Terminal Value
Just like you did with the other cash flows, you need to discount the Terminal Value back to today. Use the same formula as before:
Terminal Value(1+r)t\frac{\text{Terminal Value}}{(1 + r)^t}(1+r)tTerminal Value
This gives you the present value of all those future years beyond your forecast.
Step 6: Add It All Up
Now, the final step! You’ve got the present value of all the forecasted Free Cash Flows (from Step 3), and you’ve got the discounted Terminal Value (from Step 5). Add them together to get the Enterprise Value (EV) of the company. This is what the company is worth based on your DCF model.
Step 7: Calculate Equity Value
You’re almost done. To figure out the company’s Equity Value, you’ll need to subtract any debt the company owes and add any cash it has. Why? Because Enterprise Value is the total value of the company, including its debt and cash.
Step 8: Find the Share Price
Finally, divide the Equity Value by the number of shares the company has outstanding. This gives you the estimated stock price based on your DCF model.
As an academy member you can get access to my complete module on how to build your own DCF from scratch. Go to discord and look from Academy/lectures section for our ROIC Academy lectures archive.
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Relative Valuation
Another way to figure out if something’s worth your money is to compare it to similar things. It’s like shopping for a car and comparing prices for similar models.
Some ways to compare:
Price-to-Earnings (P/E) Ratio: This compares a company’s stock price to its earnings. If a company’s P/E is way higher than its peers, maybe it’s overpriced.
EV/EBITDA: Don’t worry, I’m not going to make you memorize that. Just think of it as another way to compare companies by looking at their earnings before the asshole accountants screw everything up (interest, taxes, etc.).
What If Things Go Wrong?
We can all admit that predictions about the future aren’t always right (remember when people thought we’d have flying cars by now? - Back to The Future thought it would be in 2015 folks).
That’s why we need to account for uncertainty.
Two ways to do this:
Scenario Analysis: You look at different scenarios: what happens if things go great, or if they go wrong, or if they go somewhere in between. It’s like planning a beach vacation and getting 3 days of rain.
Sensitivity Analysis: This tests how sensitive your valuation is to changes in things like growth rates or discount rates.
Market Mood Swings: It’s Not Always About the Numbers
Even if you calculate a company’s value down to the penny, the market might disagree, often because of emotions. People sometimes panic sell or buy like there’s no tomorrow, and that can make prices swing wildly.
But remember: just because the market is having a mood swing doesn’t mean you should. In the long run, value tends to win out, so patience WILL pay off.
As an academy member you can get access to my complete module on RELATIVE VALUATIONS. Go to discord and look from Academy/lectures section for our ROIC Academy lectures archive.
Valuation: Part Science, Part Art
Sure, there are formulas and numbers, but valuation also involves a little bit of intuition. Numbers don’t tell you everything. You’ve got to think about things like:
Management Quality: Is the leadership team capable, or do they seem like they might drive the company into the ground?
Competitive Position: Does the company have a cool new product that nobody can compete with, or is it just another gadget?
Trends: Is the company set to take advantage of the next big thing, or are they stuck in the past?
Valuation isn’t magic, it’s a mix of numbers, logic, and a bit of judgment. It helps you make sense of what things are really worth, even when the market seems a bit crazy.
Comments
Generico Fakero
🫡
Tom
Good stuff, Tom. Thanks.
