The value of something is the revenue minus the cost.
So whether we’re looking at an investments and want to actually invest into a security or more likely we’re often looking at companies, what is a company worth? What is a product worth? What is a project worth? I remember my very first lesson in valuation at an extremely young age.
In my house, we had a lot of antiques, I come from a long line of antique collectors and I looked at a particular antique and I asked my father, and I said, dad what is that worth? And he said whatever someone will pay for it.
I said come on dad, what’s it worth? He said really, it’s worth what someone will pay for it.
So what is something worth? How do we do this? Well, there’s a few different ways we have of valuating things in finance.
One of these, the first one, the easiest one, is simply called market valuation.
Now market valuation really only works with a publicly traded firm or security.
What you do is you get online, or you look at the stock market, you look at what that company is trading at.
You then multiply the market value of the share times the number of outstanding shares and there you go, you’ve got the value of the firm.
Now that value we refer to as market capitalization or market cap.
Let’s assume that the GAP has 1,106,000 shares outstanding at a current market value of $43.10 a share.
So that’s the market valuation technique, finding market cap.
What’s not accurate about this? The market says that this is what gap is worth.
My father told me that something is worth what people are willing to pay.
So isn’t that what Gap is worth? Well yeah, in the purest sense that’s what the market is willing to pay for it.
That other value might be more significant than the market value.
Why is this? Well, who’s the market driven by? The market is driven by traders, and the public, people who jump on and say hey, I’ll buy a few shares of Gap, I’ll sell a few shares of Gap.
What is the market driven by? Funny enough, that market is largely driven by ignorance.
So what is Warren Buffett saying? Warren Buffett is saying the market doesn’t know.
So the market as they follow whatever opinion leader they choose to follow, or follow whatever trend appears to be going on.
This probably is not going to be the market capitalization, although we will very well use market capitalization as a basis.
We can do it quickly, we can do it easily and it’s very useful because if we do market cap and we can do it in a matter of seconds, we can then use another valuation technique and see, based on the other valuation technique, if market cap is over valuing or under valuing the firm.
4.2 Valuation Methods
We’re in module four, which is valuation methods, and we’re now going to look at the second method of company valuation.
How does the market, how do professionals tend to decide whether this company is strong or weak? And that changes from industry to industry.
I was actually teaching this exact course, a finance course, just a couple months ago, and I used an example of a company.
Because when we did the DuPont method, they realized that the profit margins of this company, the operating margins were extremely, extremely low.
Yet they were kind of puzzled at first because they thought, wow, how could that be so low and yet the ROE be so high? And then I reminded them and said, well, look at the size of this company, and look at the name of the game of this company, right? Look at what this company is actually doing.
Because of the nature of the company, it was okay that profit margins were very low.
What mattered is that everything else was very high, right? So, in that particular sector industry, you really wouldn’t want to judge the firms by profit margin, okay? Because remember, revenue equals price times volume, right? And their volumes are crazy through the roof right? So that’s what you got to consider when you’re evaluating companies, is what’s going to be important to look at in this company? That’s the backbone of multiples.
Let’s do an example, okay? We’re going to take a company in an industry.
So we got a company, we’re going to call it company A. We want to find out what is company A worth.
Maybe we’re looking at buying company A, and we want to make an offer.
Maybe we’re looking at selling company A. We’ve got to figure out what we want to ask.
So company A just to set up a situation, we have $100 million in debt, right? So we owe $100 million.
Now what we’re going to do is we’re going to look at companies in the same industry.
Now, what we’re going to do here is we’re going to do our research and put together the numbers and we’re going to do this for every company that we’re evaluating.
You don’t want to choose 10, 12 companies, you want to choose three or four other companies.
So what we’re going to do is get their financial statements, and we’re going to pull the relevant metrics that we want to work with, the relevant numbers.
So to perform our multiple analysis, what we’re going to do is we’re going to choose four companies in the same sector.
These are four companies in the same sector, the same industry, and we’ve pulled their numbers and we’re basically just going to look at them.
So we take the market cap for each company and we divide it by sales, divide it by EBITDA, and divide it by earnings, okay.
Doing that, we get these multiples for the four companies that we’re going to use as a comparison for the company that we want to evaluate, which we’ve called company A. So we’ve got our multiples here in the table, you see them right here.
3.1, 8.1, 12.6, okay? Now, we’re going to take those and we’re going to apply them to Company A that we want to evaluate, the company we’re interested in.
Gives us a range based on what other companies are doing, and what other companies are worth on the market.
So as we go to market with this, if we’re trying to buy this company, we know that it’s worth 405 to 465.
If we want to sell this company, we believe this company is worth $465 million.
That’s basically the range, and if a fair price is paid for this company, based on multiples, it will be purchased for somewhere between $405 and $465 million.
4.3 NPV and IRR
Discounted cash flow uses the company’s free cash flows and a discount rate to calculate what we call the NPV, or net present value.
What is net present value? Net present value takes into consideration the concept of the time value of money.
What’s the time value of money? Quite simply, money today is worth more than money later.
There’s the benefit that you could have made with that $100. So money more is worth more than money later.
So how much more, right? What is, how much more is money worth a year from now than today? It’s not just the inflation rate.
It depends on who has that money, how they’re going to use that money.
If I looked at the Gap, and I wanted to know what is Gap’s money worth today as opposed to later? I want to know how much money costs them, okay? There’s another concept.
When I get money from somebody, I have to pay for that money.
You got to buy money at more than you’re buying it for.
Why? Because money costs more than what you’re getting, right? You, the, the premium on the money that you’re paying, you think of as your interest rate.
What’s my APR, my annual interest rate, ‘okay? That’s what you’re paying for your money.
Well, what does Gap pay for their money? Well, it depends where they get it from, right? What are the main sources of money? There’s debt and there’s equity, ‘okay? Debt is when Gap goes to their banks and says, hey, we’d like to borrow money, ‘okay, and the bank says, sure.
There’s another way that Gap can get money also.
Well, why not all debt? Well, all debt, and you’re extremely leveraged, you might have trouble paying back some of this you know, some of this money that you owe.
Whereas equity, its investment, you only pay your owners if you make money.
When you make money they expect more, okay, so debt is cheaper than equity.
The weighted co, average cost of capital is going to be that company’s discount rate.
The discount rate is kind of like their APR, right? It’s what they pay from money.
So when we calculate the weighted average cost of capital, we can discount their future cash flows by that amount of money and see what it’s worth in the future.
Now we need to look at what does money cost us? So we simply calculate our WACC.
Now if that NPV is zero, very unlikely but if they had zero, then that means we make no additional money.
This is break even, right? We make no additional money by in, by engaging in this investment and we lose no money.
If the NPV is negative, then that means that the money would return to us, is worth less in today’s money than the money we’ve put in.
No, because money now is worth more than money later, and it turns out, possibly depending on how that money comes in, and the discount rate, it could be that that 1.5 million discounted is less than 1 million in today’s money.
Because currently we’re paying 12.4 whatever I said, 12 point something percent for our money.
Assuming that that’s what this money costs us, that we’re investing, we’ve actually brought back more money in.
Now NPV gives me a monetary value, right? It says that this investment is worth, in today’s money, $200,000, $300,000, whatever it is, right? Because the money that I’m going to get back from that company, once discounted, is worth this premium.
It’s almost as if this is you, the rate of return on your money.
IRR will then say, for example, 21% and that’s the rate of return on the money.
If the IRR is greater than our discount rate, it’s a good investment.
If the IRR is less than our discount rate, it’s a bad investment.
We’re going to lose money, okay? I like to do both, I like to perform both NPV and IRR.
If it’s greater than your discount rate, you’re making money.
IRR, if you make the IRR your discount rate, so change it from whatever your WACC is to what the IRR is, your net present value should be zero, okay? Because that’s the actual discount rate of the, of the money to, to make the NPV equal zero.
So that’s a very brief, a basic overview, of how you use cash flows to valuate a firm, by discounting them with the discount rate, which we’ve been calling the WACC, the weighted average cost of capital.
Because, how about if I, if, if I want to invest in a project, what’s my WACC, right? I’m not going to call it a whack, right? It’s I’m going to call it my discount rate.
What I have is I have my next best opportunities, right? What’s the bank going to give me if I take my $20,000 and put it in the bank, what’s the bank going to give me? If I take and loan it to my brother, what’s my brother going to give me if I charge my brother interest? What can I do with this money, right? There’s also what kind of risk do I associate with this money? ‘Kay, if I’m going to give you money to start a business, how risky do I think that is? So, I’m going to decide what a discount rate that I want.
You can Google this, you can research this a little bit more and understand it a little bit more, but finding the discount rate, understanding the discount rate is important, not just for a company but even more importantly really for yourself.
Is what is my discount rate, what do I expect as a return for the money that I invest? Now in case you’re wondering, and I wasn’t going to show you the, the big complex formula or anything, but I do want to show you really quickly how a very simple WACC would be calculated.
So their WACC is going to be the weighted average 45% of times 6%, 55% times 13%, and that’s going to give us a weighted average cost of capital of 9.85%. So that would be the discount rate that that company would use, and they would want any investment that they got into to have an IRR greater than 9.85%. And using 9.85% as their discount rate, they would want NPV to return a value greater than zero.
4.4 Course Summary
This concludes this module and this course on finance for non-financial professionals.
Hopefully the exercises that you’ve been doing have helped you understand and integrate a bit of this learning but as you can see, there’s really, there’s a lot more to learn on this topic and it’s important for us to know this because this affects everybody in business and everybody really with a life and we, even outside of business we buy homes, we buy cars, we invest in our retirement,.
You can bring a little bit more life to the conversation and get more involved and get other people more involved, and this will help propel you to the next level of your career and the next level of your life.