How to value a business?

Great question @PPercentages, it might be best to start by stepping back and asking why you want to in the first place.

The objective of active investment in equities is to beat the market return over the long term.

Otherwise, you can invest in the index and get the market return with no effort and little cost.

Your return will be a function of the price you pay (easily observable in the market) and the price you receive (or could receive / unrealised gain on your portfolio) at the end of the investment. This future price is unknowable.

This approach ignores any other cashflows, like brokerage and dividends, for simplicity and because any market beating returns will need to come from capital gains.

So if you can’t know the future price, how do you know if the current price is a good entry point?

Value Investing – I believe this is the only theoretically sound method of investing, anything else is more akin to speculation or gambling than investing.  The most successful investors over a long period of time have been value investors.  Value Investing is famously simple but not easy.

The simplicity comes from paying a price that is significantly less than the value of stock.  The difficulty comes from knowing the value of the stock.

Value investing also dictates that in the long term future prices will be reflective of future values – which are also unknowable but can be estimated.

Discounted Cash Flow (DCF) – This is the only theoretically sound method of intrinsically valuing an asset. Every other reputable method is an approximation of this. DCF just makes more of your assumptions explicit (you need to use them as inputs) whereas other valuation tools make assumptions implicitly (a bigger topic for another thread).

Valuation guru Aswath Damodaran (as @Tom73 mentions) covers this well in his 24 part free youtube course on this - https://www.youtube.com/watch?v=8vYQpWXQ5hE&list=RDLVznmQ7oMiQrM&index=2

DCF works very well for bonds as all the cashflows are known and fall over a finite period. DCF is used extensively to value bond portfolios as a result.

DCF is much more challenging for valuing a business because you don’t know the future cashflows and they are infinite, in theory at least. This difficulty presents itself when you value a business using DCF and you realise:

1) There are a huge amount of assumptions you need to make about the cashflows that extend well into the future.

2) The Terminal Value (present value of all cashflows in the longer term, say after 5 or 10 years) is the least reliable part of the valuation and is usually the biggest part.

3) Small changes to the inputs leads to large changes to the valuation.

4) Using DCF alone to determine a value for a business is predominantly quantitative whereas (I believe) much of the future value of a business is qualitative in nature.

So why use DCF at all? There are a number of good reasons:

1) Most market participants don’t use it so must be using something less theoretically sound. This can be a source of edge over the market.

2) It forces you to think more deeply about the sources of cashflow (inflows and outflows) so you should end up with a better understanding of the business.

3) You can see the sensitivities to the valuation of a particular business by varying the inputs that might arise under different scenarios.

4) Just because it’s hard, doesn’t mean you should ignore it.

5) There are ways to modify DCF to make it more user friendly (eg. Reverse DCF and using exit multiples).

6) It allows you to project how value might change over time (which should be a driver of that unknowable future price mentioned above).

Hopefully this is more helpful than confusing. It’s a huge topic that has filled many books and university lecture rooms. Still I don’t think we pause to reflect on it enough.

As always if you want the facts, go to the source - Aswath Damodaran has a tonne of great free stuff online, it will just cost you time and attention.