How to Value a Company

Learn how to value a company with discount cash flows. Valuation is unique to the company one values but the overarching principles are the same. In short, a company is valued based on all future cash flows of the business. (Discounted Cash Flows) A growth rate and interest rate is applied to these cash flows which creates the complication. (The future is unknown).

Thus there are certain other financial statement metrics that successful investors rely on to increase the probability of a successful valuation. In addition to cash flow and financial statement metrics, check out a comprehensive list of qualitative valuation considerations here. Valuations are never certain and change frequently, but skillful investors identify companies that will likely increase value over time. Valuing cash flows is one tool to help mitigate uncertainty. We can mitigate this uncertainty by reviewing return on net tangible assets, return on capital, and thoroughly understanding a company’s business and revenue streams.

Two Methods for Discounting Cash Flows

Dividend Discount Model

The dividend growth model (also used for terminal value) is the quickest way to discount cash flows. The model as constructed assumes all constant variables but is fairly versatile by adding more wrinkles to the mix. This dividend discount model doesn't have to apply to only dividends. Free cash flow or operating earnings can sub in for variable D1 or growth/shrinkage in future cash flows can be added to the denominator.

Variable “D1” is the dividend payout in currency. If a stock doesn’t pay dividends, an investor can assume a certain percentage of earnings as the D1 or just use the full earnings figure (and assume all earnings retained in growing assets). Al Rappoport introduced the concept of NOPAT which is operating income minus cash taxes plus amortization. NOPAT is a great figure to use for income because it captures the true cash nature of operations. Cash taxes is appropriate because it captures a company leveraging deferred tax liabilities. Cash expense includes this liability but is overstated if part of these taxes is moving to the balance sheet as a deferred liability. Additionally, NOPAT is more appropriate than EBITDA because it only removes amortization. Deprecation is a real cash expense as assets require annual recurring upkeep. This upkeep does not add value, instead just maintains the current value. Amortization of goodwill on the other hand isn't a legitimate cash expense. Over time, goodwill (or the brand) of a company is likely to grow over time. As economic goodwill is growing, accounting rules require the book value to be written off over 25 years. This write off is leading to an understatement in operating income and can be added back.

Variable “r” is the discount rate or in other words the cost of equity capital. The cost of equity is the cost to the firm of raising equity financing. One can view this as more of an opportunity cost vs a cash outflow cost (such as debt financing). This figure is derived via couple different ways. One can use the Capital Asset Pricing Model (CAPM). One can google the formula, but essentially one is taking the market return premium, multiplying by a specific company’s ‘beta’ and then adding the risk-free rate. The model assumes efficient markets and is capturing the opportunity cost the market is allocating towards an individual stock compared to the market (S&P 500). Another way to calculate “r” is just to assume cost of equity. Most will assume anywhere between 8% and 15%. Finally, one can use the current 10-year treasury (risk free) rate, plus a market premium. I use Aswath Damodaran's equity risk premium found here: Damodaran On-line Home Page (nyu.edu )

If an investor uses the CAPM, here are resources for identifying the variables:

Risk-free rate: Yahoo Finance 10-year treasury yield (^TNX)
Beta: Yahoo Finance on a company's summary page right below the chart
Market Risk Premium: Damodaran On-line Home Page (nyu.edu )

Variable “g” is the constant growth rate of cash flows. Three methods are most common but are all loose assumptions.

Assume the cash flows will grow according to gross domestic product (GDP). In the US case, 2-3%.
Assume growth according to an individual firm's reinvestment rate.
Assume no growth rate. This is the most common scenario for this model as constructed as it's commonly used for the terminal rate. Theory suggests that after some competitive advantage period (ROIC > WACC) the company will only earn the cost of capital (WACC). When this happens, there is no growth in value. More revenue and higher net income only means equal proportion to cost of capital.

An example of how to use this Dividend Discount formula:

Say a company doesn’t pay dividends but has NOPAT earnings of $100 dollars annually. We’ll assume a cost of capital of 10% and zero cash flow growth. Thus take $100/10% and arrive at a valuation of $1,000 or 10x earnings. If the company is determined to grow with GDP of 3% forever, then the valuation is now 14x earnings ($100/7%). Lowering the interest rate will also increase the valuation multiple.

Value a Company with Net Present Value of Cash Flows

The dividend discount model is most commonly used for terminal values on stock prices. The method to value today through that terminal value start time is a net present value of cash flows model (NPV). This model is important because it breaks investments and cash returns into individual periods. (usually a year) Another defining difference between NPV is that it accounts for recurring investments in each of the periods. These recurring investments are working capital, property plant and equipment purchases, and acquisitions.

The net present value of cash flows is more refined then the dividend discount model but follows the same rules with the same variables. The main differences are:

The investor can choose what the cash flows are in the future and how long the cash flows last.
The investor can select different discount rates and different growth rates throughout the model timeline.
This model will work better when risk free interest rates are low.

All companies can be priced at the present value of future “expected” cash flows. Where things get tricky is assessing the duration and valuing creating nature of these cash flows. This valuation changes frequently in the short term but is more consistent long term. Due to volatility in cash flows, value investors assume conservative variables to maintain a margin of safety in valuations.

Return on Net Tangible Assets

Measure the economic value of cash flows by looking at the return on net tangible assets (net tan). Net tan in this case is net property, plant, and equipment (PPE); plus, inventories; plus, accounts receivable. Net tangible assets are a company’s operational assets, and an investor wants those assets to show a high rate of return. (For example, why would an investor want to invest in assets that return less than the risk-free rate. At that point, why not buy treasuries). Think of a company’s return on net tangible assets the investments a company needs to operate the core business operations. A retail company will rely heavily on buildings and inventory. A trucking company will rely heavily on PPE (Trucks, trailers, terminals). A technology company relies heavily on accounts receivable and data infrastructure.

To calculate return on net tan simply take net income over (PPE + inventory + accounts receivable). Visit here for more details on Return on net tangible assets

Return on Equity and Return on Capital

The return on equity (ROE), return on capital (ROC) or also return on invested capital (ROIC) shows the efficiency of management. Good management will allocate capital (cash) appropriately to value creating ventures. Return on capital shows the return of net income over liabilities plus equity. This is important because over time a company should increase this percentage return. Net income should rise faster than the capital base (Liabilities plus equity or total assets) (Total assets = total liabilities + total equity). This is value creation.

If management is making irresponsible acquisitions by printing stock or taking on debt, then the savvy investor will notice the return on capital decreasing year over year. If management is printing stock to acquire companies, the return on equity percentage will be decreasing year over year. The investor must be confident that a company can increase net income at a higher rate than the capital base (net income/total assets).

A growth in stock will mirror growth in book value and/or increase in return on equity over time. Find out more here:

Revenue

How a company generates sales (revenue) is absolutely essential to understanding the value of a company. Sales are essential because cash flows or any “metric” will always be volatile, but understanding what the company sells creates clarity for long term confidence. During recessions, cash flows drop and may go negative, or the company may experience growing pains that result in a severe drop in valuation or even cash flows. The diligent investor must have a great understanding of how a company generates sales and why sales will continue and expand into the future. To understand sales, check out our articles on why revenue is important: Here. Also, learn where to find revenue and other value considerations here.

How the Pieces Fit Together

Cash flows, return on tangible assets, return on equity, and revenue all flow together to paint the picture of an investment. Imagine investing in a company with very low return on intangible assets (say 5%). The company may show a high value according to the discounted cash flows at one point in time, but those cash flows are more exposed to inflation, economic downturn, or competition.

Return on equity is only as good as the debt load in the capital structure. Real estate or leveraged buy outs are great examples. Investors look to increase return on equity by using mostly debt to finance the purchase of an asset. In cases where the return on equity is high but return on tangible assets is low suggests that the company is over leveraged.

An investor generally needs a company with high return on tangible assets, high return on equity, and healthy cash flows.