Valuing Opportunities: How much is a company worth?
Finding undervalued opportunities is core to investing, and the basis for making outsized returns. But finding such opportunities requires an understanding of how companies are valued — a field commonly studied in academic settings under the umbrella of 'corporate finance'.
That's what we discuss in this post, and a series of follow-up posts covering each valuation method in detail.
Imagine you're given the job of figuring out how much a company is worth, it's 'fair value'. How would you go about doing that?
It's daunting to imagine doing this exercise for large companies like Microsoft or Apple, so let's scale it back.
Imagine a grocery store.
An easy way to estimate what it is worth is to simply add up the value of all of the items in it.
Already, we encounter a decision that needs to be made: should we use the 'price' (what the items are selling for) or 'cost' (how much the items cost to purchase)?
As it turns out, there are actually two accounting methods for recording the value of an asset. Mark-to-market accounting (or 'fair market value') considers the current market value of the asset (i.e. the 'price'), whereas Historical-cost accounting considers the original cost it was purchased at. Today, fair market value is the most widely recognized valuation standard.1
Of course, we'd also need to consider the store's liabilities — like any debt that may have been used to purchase inventory. Subtracting the liabilities from the sum of all assets gives us the expected 'fair value' of the business.
Asset-based valuation, like what we just did here, is the simplest method for valuing a company — and it's often used when there's no equity in a company. There are a few more nuances to consider when applying asset-based valuation, something I'll cover in a future post.
It's important to recognize that asset-based valuation disregards a company’s future earnings potential — making it unsuitable for growth companies.
Discounted Cash Flow (DCF)
A pretty nasty shortcoming of asset based valuation is that it ignores growth potential entirely. Many startups in Silicon Valley begin in garages. Asset based valuation would have us believe that all garages are worth roughly the same — even though in 5 years, one could be the next Microsoft and the other could just be, well, a regular garage.
We need a valuation method that factors in future growth. That's where Discounted Cash Flow (and the Dividend Discount Model below) come into play.
Here, we estimate the money an investor would receive from an investment, adjusted for the time value of money.
'Time value of money'? Yes, it's the idea that a dollar today is worth more than a dollar tomorrow. If you had it today, you could put it to work and have more than a dollar tomorrow. So, essentially, we need to 'discount' future money to figure out what it's worth today… the further out it is, the greater the discount. That's what the 'discount' in Discounted Cash Flow means.
So what are we discounting? Future free cash flow. Free cash flow is the cash that's available to a firm's investors, before getting distributed to debt holders, equity holders, or reinvested back.
I'll dedicate a future post to cover exactly how we calculate DCF, but for now — just consider that DCF relies pretty heavily on predicting free cash flows into the future, and that this is it's biggest drawback.
It's hard doing that, and since it's such a central part of the calculation, even small mistakes can result in huge variance in the outcome. That's why DCF is often used for companies that are past the growth stage, and have more stable growth attributes as a foundation for this calculation.
Dividend Discount Model (DDM)
This is a special application of the DCF model just discussed, that only considers the amounts paid out as dividends (and not all 'free cash flow' generated by the company). The company is valued based on the present value of future dividends.
Naturally, this would only apply to companies that pay dividends in the first place — and that do so on a regular basis, which tend to be more mature companies. It's also worth noting that dividends are discretionary — companies are not forced to pay out dividends.
More details into the calculation of the DDM model will follow in a future post.
Residual income is the income a company generates after accounting for the cost of capital. (income - cost of equity)
We're basically factoring in the opportunity cost for shareholders.
Residual income models look at the economic profitability of a firm rather than just its accounting profitability
The residual income valuation formula is very similar to a multistage dividend discount model, substituting future dividend payments for future residual earnings. Residual income models make use of data readily available from a firm's financial statements. These models look at the economic profitability of a firm rather than just its accounting profitability.
- Financial Account Standard Board. Fair value: The price that would be received to sell and asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.↩