Finance 01 Basics

Valuation Basics

• Valuation involves assessing an asset's worth based on fundamental characteristics.
• Intrinsic value of a cash flow-generating asset depends on the size and certainty of future cash flows.
• Discounted Cash Flow (DCF) valuation discounts future cash flows to their present value, adjusting for risk.

Essence of Intrinsic Value

• Intrinsic value is determined by an asset's fundamentals.
• Cash flow-generating assets are valued based on the expected magnitude of cash flows over their lifespan, considering uncertainty in receiving them.
• DCF valuation is a tool used to estimate intrinsic value.
• Intrinsic valuation models preceded modern DCF models; investors have consistently incorporated expected cash flows into valuations.

Two Faces of DCF Valuation

• A risky asset's value is calculated by discounting expected future cash flows at a risk-adjusted rate.
• Alternatively, expected cash flows can be replaced with their certainty equivalents and discounted at the risk-free rate.

Risk-Adjusted Value: Two Basic Propositions

• Asset value equals the risk-adjusted present value of its cash flows.
• "IT" proposition: Risk or non-cash flow impacts don't affect a company's value if they do not impact the expected cash flows.
• "DON'T BE A WUSS" proposition: Estimating future cash flows is crucial for valuation; uncertainty isn't an excuse for not making estimates.
• "DUH" proposition: For an asset to have value, it must generate positive cash flows at some point.
• "DON'T FREAK OUT" proposition: Early cash flows are more valuable than those further into the future, though later cash flows can have higher growth potential for compensation.

DCF Choices: Equity Versus Firm Valuation

• Firm valuation: Values the entire business. Assets include existing investments, assets in place, and growth assets. Liabilities include debt.
• Equity valuation: Values just the equity claim within the business.

Equity Valuation

• Cash flows are considered after debt payments and reinvestment needs.
• Discount rate only considers equity financing costs.

Firm or Business Valuation

• Cash flows are considered before debt payments but after reinvestments.
• Discount rate includes both debt and equity financing costs in proportion to use.

Firm Value and Equity Value

• To derive equity value from firm value, subtract the value of all liabilities in the firm.
• Resulting equity value will be higher than a stand-alone equity valuation due to factors like debt.

Cash Flows and Discount Rates

• Example data demonstrates cash flow (to equity, to the firm) for five years, terminal value, cost of equity, cost of debt, tax rate, current equity market value, and outstanding debt value.

Equity Versus Firm Valuation

• Method 1: Calculating equity value by discounting cash flows to equity at the cost of equity.
• Method 2: Calculating firm value by discounting cash flows to the firm at the cost of capital to derive equity value from the value of the firm less the market value of the debt.

First Principle of Valuation

• Discounting Consistency Principle: Never mismatch cash flows and discount rates.
• The Mismatch Effect: Mismatching cash flows and discount rates leads to problematic valuation estimates.

The Effects of Mismatching Cash Flows and Discount Rates

• Errors occur when mismatching either cash flows to the firm or to equity and using different discount rates.
• Errors can overstate or understate equity value.

DCF: First Steps

• A brief introductory statement about DCF's processes.

Generic DCF Valuation Model

• Presentation of a generic DCF valuation model demonstrating the key input factors such as Cash Flows, Expected Growth, Discount Rate, and Terminal Value calculations.

Same Ingredients, Different Approaches

• Detailed explanation of the Dividend Discount Model, FCFE, and FCFF valuation approaches to show the differences in accounting treatments of cash flows and discount rates.

Start Easy: The Dividend Discount Model

• A detailed summary of the Dividend Discount Model, considering net income, payout ratio, expected growth (in net income), cost of equity, and stable growth to define the model's limitations.

Moving on Up: The “Potential Dividends” or FCFE Model

• A detailed explanation of the Free Cash Flow to Equity (FCFE) Model, outlining considerations such as non-cash net income, changes in non-cash working capital, and debt financing to derive equity value.

To Valuing the Entire Business: The FCFF Model

• A detailed explanation of the Free Cash Flow to the Firm (FCFF) Model, outlining the difference in terms of accounting treatment and cash flow and discount rate, showing considerations for operating income, capital expenditures, change in noncash working capital, reinvestment, and cost of capital.

DCF: The Process

• A presentation of the DCF valuation process, explaining the steps from estimating past and current financial data, forecasting future cash flows, calculating the cost of capital for discounting future value, and applying the appropriate closure for valuation.

The Sequence

• Explains the five-step sequence in the valuation procedure, emphasizing the importance of considering past data, risk assessment, forecasting, and closure to reach a comprehensive valuation.