Session 2: Intrinsic Value - Foundation

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 to be one tool that can be used to estimate in 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 it could entirely be in the eyes of 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 fam famar one at least for those who've taken a finance class in fact you probably saw 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 a rocket science people have always understood the fundamentals of discounted cash flow valuation even before we and 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 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 as outcome so the expected cash flow is just the expected cash flow it's not R adjusted the discount rate is where you adjust for risk risk your 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 AV 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 problema say I knew that already you 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 expected 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 doar 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 2 year three that's okay in fact that's what you'd expect but what you should also expect to see a 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 in 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 5 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 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 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 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 he 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 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 investor 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 still interest 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 the cost of equity you can value the equity indirectly by valuing the business and subtracting our 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 the cost of capital don't discount cash flows 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 evaluation 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 valuations about valuing companies based on their specific characteristics this 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 equivalence or adjusting the discount rate for risk and you have to make a choice are you valuing the equity in the business valuing the entire

business that choice will govern how you estimate the cash flows and what discount rate to use