What a company is worth
What a company is worth follows from all the payments it will make to its owners in future, converted to today. The calculation is simple. The assumptions in it aren't.
Learning objective: After this lesson you can explain how a company's value follows from future payments and why the assumptions decide it.
If someone promises to pay you €1,000 every year for ten years, that's not worth €10,000 today. Money in the future is worth less than money today, because you have to wait and because it's not certain it'll come. At 8 percent, the ten payments are worth about €6,700 today.
How a Company Is Valued
A company is valued the same way. You estimate what it will earn in future and can pass on to its owners, and convert it back to today. The total is called the intrinsic value. If the share price is well below it, the share counts as cheap.
The Problem With Assumptions
The catch is the assumptions. You have to estimate how fast the company will grow and what interest rate you use to convert back. Small changes to these two numbers change the result a lot.
Valuation as a Range
A valuation is therefore a range, not an exact number. If someone gives you an exact fair value, they've either misunderstood something or want to sell you something. The calculation is still useful, because it shows what expectations are already in the price. If you do this by fixed rules for many companies rather than one, you end up with value investing as a strategy, which has been researched and argued about for decades.
With the discounted cash flow model, you estimate the payments for the next five to ten years one by one and a terminal value for the period after. This terminal value often makes up two thirds or more of the whole result. So the result depends mainly on assumptions about a time far beyond anything you can seriously forecast.
The Terminal Value
For the terminal value people usually use a formula with constant growth: next payment divided by (interest rate minus growth). The result reacts strongly to the gap between the two. At 8 percent interest and 2 percent growth, one percentage point more growth makes the terminal value about 20 percent bigger. At 8 and 5 percent, the same percentage point already makes it about 50 percent bigger. A single exact number as the result is therefore not credible.
Working Backwards
The reverse route is often more sensible. You ask what growth and profit margins today's price assumes, and then judge whether that's realistic. That way you don't have to invent a forecast of your own with false precision, and you see clearly what the market currently expects.
Summary
- The terminal value usually decides most of the result.
- Just one percentage point more growth can change the value by a fifth or more.
- More useful than your own forecast is asking what's already in the price.
Did you get it?
Why is money in the future worth less?
Because you have to wait and it's not certain it'll come. That's why it's converted back to today.
Which part usually decides a valuation?
The terminal value, meaning the assumptions for the time after the actual forecast period.
Which route avoids false precision?
The reverse one: working out which assumptions would justify today's price and checking whether they're realistic.
Check your understanding
Your task
Calculate the present value of ten payments of $1,000 each, once at a 6 percent discount rate and once at 10 percent, for example in a spreadsheet. Write down by how many percent the two results differ and what that means for any claim that a company has an exact fair value.
Sources and further reading
- Aswath Damodaran's analysis of terminal value in company valuation, showing how heavily a discounted cash flow model's result depends on the terminal value and its assumptions. View source ↗
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