I get asked a lot what people in financial services actually do for a living. It’s a fair question, as their contributions aren’t clearly visible to most of society.

For startup founders, a basic understanding of corporate finance is vital, as just a few concepts underlie some of the most important strategic decisions you will have to make, both in a company’s infancy and during mature phases of growth.

Investment bankers and many buyside investors spend much of their time valuing companies, whether it be to determine if the target would make a good investment, or to determine a purchase price for a prospective acquirer. Knowing these fundamentals will help entrepreneurs understand where the valuation of a company is coming from, and whether or not it makes sense.

Overview

There are two kinds of valuation:

1. Intrinsic — determines value of a company based on the sum of expected future cash flows, adjusted for uncertainty and risk (using a discount rate).
2. Relative — determines value of a company by comparing the target to similar companies in the sector. For example, pricing Microsoft based on how Google trades on the stock market.

The most common tool associated with intrinsic valuation is called a discounted cash flow analysis, or DCF. The most common forms of relative valuation are comparable companies analysis and precedent transactions analysis. I’ll explain all three methods eventually.

In this post, I’ll cover DCF.

Discounted cash flow analysis

Discounted cash flow analysis is the most thorough and widely-used method of intrinsic corporate valuation. It seeks to value the company based on future cash flows— it is known as being ‘discounted’ because money in the future is not worth as much as money right now.

The ‘discounting’ of the value of future money is due to the fact that inflation lowers the value of money in the future, and also to the fact that, should the money be given immediately, there is always the option of investing and gaining a positive return, especially if the return is a guaranteed positive (risk-free investments, such as government bonds or savings accounts). The discount rate, therefore, is the rate chosen to discount the future value of money — usually just the percent return of a risk-free security. So:

Net present value = (Future value)/[(1 + discount rate)^n], where n is the number of years in the future (number of times investment will give risk-free return).

There are two methods of performing DCF analysis: Weighted average cost of capital (WACC) or adjusted present value (APV). They have different methods of calculating the discount rate, which is what separates them.

One method of discount rate calculation is known as the Capital Asset Pricing Model(CAPM), which was a Nobel Prize-winning discovery. CAPM calculates expected return on investment, or expected return on equity. It is a single variable linear model based on the value of equity Beta, which represents the relative volatility of an investment relative to the market. Volatility is the amount that the investment in question moves relative to the market — if Beta is equal to 1, the stock generally follows the general market, whereas if the Beta is equal to 3, it would generally rise or fall 3 times as much. Beta can also be negative, which indicates the stock moves contrary to the flow of the rest of the market.

Mathematically:

Discount rate for an all-equity firm = Risk-free rate + Equity Beta*(Market return — Risk-free return)

Information regarding all the variables can be found on many finance websites.

Free cash flows (FCFs) are all the extra cash flows a firm has after it’s settled its obligations. The FCF of an all-equity firm can be calculated by:

(Earnings Before Interest and Taxes)*(1 — corporate tax rate) + Depreciation and Amortization — CapEx — Net Increase in Working Capital + Other relevant cash flows

EBIT can be obtained from the income statement.

Depreciation and Amortization can be obtained from the balance sheet.

Both capital expenditures (CapEx) and the net increase in working capital can be obtained from the statement of cash flows.

And, for an all-equity firm, other relevant cash flows would include items like asset sales (selling real-estate, for example).

All the information can be found on financial statements, but note that DCF analysis is based on future FCFs, which are usually constructed through model projection or reasonable estimation by analysts.

The most commonly used method for building a DCF model is probably the Weighted Average Cost of Capital method, or WACC. The other model, Adjusted Present Value (APV), will not be addressed in this post.

WACC is based on finding a discount rate that depends on the ratio of debt and equity to the overall assets of the company. Remember that assets = owners’ equity + liabilities. WACC weighs the discount rate of debt and equity based on their respective ratios to the total assets of the corporation. In other words, the equation is something like this:

WACC = (Percentage of total assets that is equity) * (Discount rate of equity) + (Percentage of total assets that is debt) * (Discount rate of debt)

The discount rate of debt is the current rate that the company is paying on its debt, which is fairly straightforward to find. The discount rate of equity can be found through the Capital Asset Pricing Model (CAPM), which goes like this:

Discount rate of equity = Risk-free rate of return + Beta * (Market risk premium)

Where the risk-free rate of return is usually the yield on the 30-year treasury bond, the Beta is the volatility of the stock in question (can be pulled off of many financial sources), and the market risk premium is the rate of return of the S&P 500 over the yield of the 30-year treasury bond.

When all variables are inputted into the overall WACC equation, the result is a discount rate that is used to compute the value of the future cash flows of the company being valued.

The cash flows calculation is less straightforward. As a DCF is based on future cash flows, no one can actually determine exactly what the company will earn several years in the future, so financial analysts analyze present-day information to make an educated guess regarding the value of these cash flows during the growth years (years during which growth will continue to decrease).

After the growth years comes the terminal year, after which all the growth rates become a constant, sustainable rate. To calculate the worth of all free cash flows during and after the terminal year, we can use the Gordon Growth model. The terminal value of the company is calculated by the following formula:

Terminal value = [(Final projected year cash flow)*(1+Long-term cash flow growth rate)]/(Discount rate — long-term cash flow growth rate)

When all values are computed, they are added together to find the value of the company.

So, in essence, the DCF analysis values a company by adding up the projected future cash flows of the company during its growth years and then adding up its terminal value. This values a company by the revenue it will generate in the future, which subjects it to analyst predictions and estimates.