Session 2: Intrinsic Value - Foundation

Introduction to Intrinsic Valuation

The speaker introduces intrinsic valuation as a technique for valuing a business based on its specific characteristics, such as cash flows, growth, and risk. They also explain that intrinsic valuation is designed for cash flow generating assets.

What is Intrinsic Valuation?

• Intrinsic valuation is the value of a business based on its expected cash flows, growth, and risk.

• It lies at the core of almost everything we do in valuation.

• It is a technique designed for cash flow generating assets.

Discounted Cash Flow Valuation

• The equation that drives discounted cash flow valuation is: the value of an asset is the present value of the expected cash flows on that asset.

• This kind of cash flow valuation boils down to estimating cash flows and adjusting for risk.

• There are two ways in which you can set up a discounted cash flow valuation:

• Get the expected cash flows on an asset or business over time expected across all scenarios

• Adjust the cash flow for risk

Two Ways of Doing Intrinsic Valuation

The speaker explains two ways to do intrinsic valuation when looking at a business: valuing equity or valuing the entire business.

Equity Valuation vs. Business Valuation

• When looking at a business, you can either value the equity in the business or you can value the entire business.

• Equity valuation involves determining what portion of ownership in a company would be worth owning.

• Business valuation involves determining what an entire company would be worth if it were sold.

Risk Adjusting Discounted Cash Flows

The speaker discusses how to adjust discounted cash flows for risk.

Risk Adjusting Discounted Cash Flows

• To adjust discounted cash flows for risk, you can either adjust the discount rate for risk or adjust the cash flow for risk.

• Adjusting the cash flow for risk involves determining a certainty equivalent cash flow, which is a guaranteed cash flow that an investor would accept in place of a risky cash flow.

• For an asset to have value, its expected cash flows have to be positive at some point in time. If a company is losing money and is expected to lose money forever, it has no value.

Basic Propositions of Discounted Cash Flow Valuation

The speaker discusses two basic propositions of discounted cash flow valuation.

Basic Propositions

• For an asset to have value, its expected cash flows have to be positive at some point in time.

• If you have a business with negative cash flows upfront, it has to have disproportionately large positive cash flows in the future.

Discounted Cash Flow Valuation

In this section, the speaker explains the concept of discounted cash flow valuation and how it can be used to value a business.

Financial Balance Sheet

• A financial balance sheet is simpler than an accounting balance sheet but more complex in terms of items on each side.

• The asset side of the financial balance sheet has two types of investments: investments in place and growth assets.

• The liability side of the financial balance sheet has only two items: debt and equity.

Equity Valuation vs. Business Valuation

• When valuing equity, only cash flows to equity investors are considered, and the discount rate used is the cost of equity.

• When valuing a business, collective cash flows to both equity investors and lenders are considered, and the discount rate used is a weighted average of cost of equity and cost of debt.

• The collective cash flow to both equity investors and lenders is called a cash flow to the firm.

Valuing Equity

• There are two ways to value equity: directly by taking cash flows to equity and discounting at the cost of equity or indirectly by valuing the business and subtracting out debt.

• Never mix and match cash flows when doing valuation.

Overall, this section provides an introduction to discounted cash flow valuation, explaining how it can be used for both valuing equity as well as businesses. It also highlights important considerations such as not mixing and matching cash flows during valuation.

Valuing Companies Based on Specific Characteristics

In this section, the speaker discusses how to value companies based on their specific characteristics using discounted cash flow valuation.

Discounted Cash Flow Valuation

• Discounted cash flow valuation is a tool used to estimate intrinsic value.

• To use this method, you need to estimate expected cash flows and adjust for risk.

• This can be done by replacing the expected cash flows with certainty equivalents or adjusting the discount rate for risk.

This section provides an introduction to discounted cash flow valuation and its application in valuing companies based on their specific characteristics. The speaker emphasizes the importance of estimating expected cash flows and adjusting for risk when using this method.