Transcription
In this session, we're going to start off with intrinsic valuation. What is intrinsic valuation? In intrinsic valuation, the value of a business is a function of its expected cash flows, growth, and risk. It is the fundamental way of thinking about valuation, and it lies at the core of almost everything we do in valuation.
During this process, we will also talk about two ways of doing intrinsic valuation. When you look at a business, you can either value the equity in the business, or you can value the entire business. Sounds mysterious, but hopefully by the end of this session, the mysteries will clear up. So let's talk about intrinsic valuation.
Intrinsic valuation, as I noted, is a technique for valuing a business based on its specific characteristics. So let me cut to the chase and talk about the essence of intrinsic value. In intrinsic value, you're trying to value a business based on its cash flows, its growth, and its risk. And discounted cash flow valuation happens to be one tool that can be used to estimate intrinsic value. The reason I emphasize that is a lot of people equate the two. They think that discounted cash flow valuation is always intrinsic value, and intrinsic value is always discounted cash flow valuation. That may or may not be the truth.
The other point I want to emphasize is intrinsic value is really designed for cash flow generating assets. So if you gave me a business, a stock, a young growth company, a startup, I can use intrinsic valuation. When can I not use it? Give me a Picasso to value. I couldn't give you the intrinsic value of a Picasso because it could entirely be in the eyes of the beholder. Another example, if you ask me what the intrinsic value of gold is, I have no idea. So intrinsic value is a technique designed for cash flow generating assets, whether it's a business or an individual asset.
So, having laid that as a basis, let's talk about discounted cash flow valuation. The equation that drives discounted cash flow valuation is a familiar one, at least for those who've taken a finance class. In fact, you probably saw it in their very first finance class. It says, the value of an asset is the present value of the expected cash flows on that asset. This is not rocket science. People have always understood the fundamentals of discounted cash flow valuation, even before we in finance start to dress it up and make it look more sophisticated than it absolutely has to be.
So, in discounted cash flow valuation, it boils down to estimating cash flows and adjusting for risk. So how do you do that? There are two ways in which you can set up a discounted cash flow valuation. In the first, and this is the more common way, you get the expected cash flows on an asset or business over time, expected across all scenarios. And I want to emphasize that if you do a true discounted cash flow valuation, you have to look at all possible outcomes, good and bad, and take an expected value across all outcomes. So the expected cash flow is just the expected cash flow. It's not risk-adjusted. The discount rate is where you adjust for risk. Riskier assets have higher discount rates than safer assets.
Here's the alternative. Rather than adjusting the discount rate for risk, you can try to adjust the cash flow for risk. A lot of people don't quite understand what this means. So let me be clear about what risk-adjusting the cash flows would mean. Let's assume you have $100 in expected cash flows next year, but you're uncertain about those cash flows. Your risk-adjusted cash flow will not be $100. It'll be whatever you would take as a replacement for the $100 as a guaranteed cash flow. Now think about it. If you're risk-averse, and I offered you a choice between $100 of risky cash flows or some other number that's a safe cash flow, you'd probably settle for a lesser number, right? 90, 95, 92. That's called a certainty equivalent cash flow. It's a difficult thing to do, but you can do it. So those are the two phases of risk-adjusting discounted cash flows.
So, having laid that as a basis, let's extend that. Take a look at those equations. The value of an asset is the present value of the expected cash flows discounted back at a risk-adjusted discount rate, or the value of an asset is the certainty equivalent cash flow discounted back at a risk-free rate because you've adjusted the cash flows for risk. Two very basic propositions flow directly from looking at that equation. They're very basic. So as I say this, you're probably saying, "I knew that already."
Here's the first one. For an asset to have value, its expected cash flows have to be positive at some point in time. Stating the obvious, right? But might as well state it. So if you come to me with a company that's losing money and you tell me you expect it to lose money forever, you know what valuation model you should use for it? None. That company is worth nothing to you. So for a company to have value, its cash flows have to be positive at some point in time. The key word is "some point in time."
If you have a business with negative cash flows up front, doesn't have to be a bad business. It could be a young startup. For that business to have value, it has to have disproportionately large positive cash flows in the future. Why disproportionately large? Because if you lose a billion dollars in year one, you better make five or 10 billion in year 10 to make up for that billion dollars in year one. So when you see me valuing young growth companies a little further down the course, don't be surprised to see these companies have negative cash flows up front, and those year one, year two, year three, that's okay. In fact, that's what you'd expect. But what you should also expect to see are very large positive cash flows down the road.
Now, here's one vehicle that I think of that I can use to think about discounted cash flow valuation. I find it very useful. When I look at a business, I can look at an accounting balance sheet. Right, we've seen accounting balance sheets. There are assets to one side, liabilities to the other. But they're accounting assets and accounting liabilities. I prefer to use what I call a financial balance sheet. A financial balance sheet, at one level, is far simpler than an accounting balance sheet. At another level, it's far more complex. There are only two items on each side. On the asset side of the balance sheet, I have investments in place. Those are investments you've already made as a business in the past. Those are the investments that are producing cash flows for you today. The other asset that you see there are growth assets. These are investments I expect you to make in the future. How far into the future? Next year, two years out, five out, forever? I'm giving you credit for investments you haven't even thought about yet. That sounds strange, right? But that's exactly what you do when you value a growth company. Right, you're giving them credit based on expectations, perceptions, hope. Nothing wrong with it. That's reality.
On the other side of the balance sheet, notice there are only two items: debt and equity. There are only two ways you can fund a business. You can borrow the money, or use your own money. Whether it's a public business or a private business, those are your two choices.
Now, here's why I like a financial balance sheet framework. When I sit down to value a business, I have to make a choice. I can value either the equity in the business, or I can value the entire business. You're saying, "What's the difference?" When I value equity in a business, I have blinders on. All I care about are the equity investors. I look at the cash flows that the equity investors get out of the business. Those are the cash flows left over after I've made my interest payments, my principal payments, all the payments due to the bank. Cash flows to equity are cash flows that equity investors can take out of the business. If those are the cash flows I'm focusing on, the discount rate I should be using is the rate of return that equity investors would need to make, given the risk of that equity. Now, we haven't looked at the details of how to do that yet, but the intuition should be pretty clear. The riskier an equity, the higher that rate of return is going to be. Cash flows to equity discounted back at that rate of return, which we call a cost of equity, is the value of equity in a business.
Now, think about it. You buy stock in a publicly traded company, you're an equity investor, right? Technically speaking, the only cash flow you actually get from the company is dividends. The dividend discount model is a special case of an equity valuation model. It's the oldest discounted cash flow model around, and you're trying to value equity based on the cash flows they actually receive from the company. As we go through this class, one of the things I'm going to talk about is what to do about companies that don't pay out what they can afford to in dividends. Let's face it, not all companies return the cash that they have available as dividends. So we'll talk about alternate measures of cash flows to equity that look at potential dividends rather than actual dividends. But you're focused on valuing equity.
You say, "What's the choice?" Rather than value equity, you could try to value the entire business. Think about it as valuing the asset side of the balance sheet rather than the liability side. So you're looking at the assets, you look at the cash flows they produce, and remember those cash flows go to service both the equity investors and the lenders. You look at the collective cash flows that both equity investors and lenders get out of the business. It's almost counterintuitive because if you're a business owner, you tend to think about the cash flows to equity as your cash flows. I'm asking you to expand your vision, look at the collective cash flows you get out of the business. That cash flow is called the cash flow to the firm. And if that is the cash flow you're discounting, the discount rate you're going to use is a weighted average of what equity investors demand, which is the cost of equity, and what lenders demand, which is the cost of debt. In corporate finance, that weighted average is the cost of capital. Your discount cash flows to the business at the cost of capital, you value the entire business.
Let's say you're still interested in the equity. It's easy to get there, right? Once you value the business, all you need to do is subtract out what you owe, the value of your debt, you should have the value of equity. So there are two ways you can value equity. You can value the equity directly by taking cash flows to equity and discounting at the cost of equity. You can value the equity indirectly by valuing the business and subtracting out debt.
You might say, "Which one should I use?" If you do this right, you should actually get the same value for equity using both approaches. But here comes one of the first principles in valuation: never mix and match cash flows. What am I talking about? Don't discount cash flows to equity at the cost of capital. Don't discount cash flows to the business at the cost of equity. You might have put in an immense amount of work coming up with the numbers, but if you mix and match, all is lost. Your valuation is going to go off the rocks. So your first step when you do valuation is to make sure you're being internally consistent, that your cash flows and your discount rates are matched up. If you're worried about that abstraction, we'll come back and flesh it out a little more as we start talking about actual valuations.
But in summary, here's what I want you to take away from this session. Intrinsic valuation is about valuing companies based on their specific characteristics. Discounted cash flow valuation is a tool to estimate intrinsic value. You need to estimate expected cash flows and adjust for risk, either by replacing the expected cash flows with certainty equivalents or adjusting the discount rate for risk. And you have to make a choice: are you valuing the equity in the business, or valuing the entire business? That choice will govern how you estimate the cash flows and what discount rate to use.