Session 2: Intrinsic Value - Foundation

Summary

The session delves into intrinsic valuation, emphasizing its focus on a business's cash flows, growth, and risk. It clarifies that intrinsic valuation, while often associated with discounted cash flow (DCF), is not synonymous with it. DCF is a method to estimate intrinsic value by discounting expected cash flows at a rate that reflects risk. The instructor introduces two approaches to DCF: adjusting the discount rate for risk or adjusting the cash flows themselves. The session also highlights the importance of positive expected cash flows for a business to hold value and introduces the concept of a financial balance sheet, distinguishing between valuing equity and the entire business, each with its own appropriate discount rate.

Takeaways

• 📈 Intrinsic valuation is a fundamental technique for valuing a business based on its cash flows, growth, and risk.
• 💡 The concept of intrinsic value is distinct from discounted cash flow (DCF) valuation, although DCF is a tool used to estimate intrinsic value.
• 💼 Intrinsic valuation is designed for cash flow-generating assets and is not applicable for assets like art or gold, where value is subjective.
• 🔍 DCF valuation involves estimating future cash flows and adjusting for risk, which can be done by altering the discount rate or by adjusting the cash flows themselves.
• 💰 The value of an asset in DCF is calculated as the present value of expected cash flows discounted at a risk-adjusted rate or as the certainty equivalent cash flow discounted at a risk-free rate.
• 🌟 For an asset to have value, it must have positive expected cash flows at some point in time; this is a basic but crucial principle in valuation.
• 📊 A financial balance sheet, which includes investments in place and growth assets on the asset side, and debt and equity on the liability side, is a useful framework for valuation.
• 🏦 When valuing equity, focus on cash flows to equity investors after all debt obligations have been met, and use the cost of equity as the discount rate.
• 🏢 Valuing the entire business involves looking at cash flows to the firm, which includes both equity and debt holders' returns, and using the weighted average cost of capital as the discount rate.
• ⚖️ Consistency is key in valuation: ensure that the cash flows and discount rates are matched correctly to avoid inaccuracies in valuation.

Q & A

What is intrinsic valuation?

Intrinsic valuation is a technique for valuing a business based on its specific characteristics, focusing on its cash flows, growth, and risk.

Why is discounted cash flow (DCF) a common tool used in intrinsic valuation?

Discounted cash flow is a tool used to estimate intrinsic value by calculating the present value of expected future cash flows, adjusted for risk.

What are the two ways to perform intrinsic valuation as mentioned in the script?

The two ways to perform intrinsic valuation are by valuing the equity in the business or by valifying the entire business.

How does risk adjustment affect the expected cash flows in a DCF valuation?

Risk adjustment can affect the expected cash flows by either adjusting the discount rate for risk or by adjusting the cash flows themselves to certainty equivalents.

What is a certainty equivalent cash flow?

A certainty equivalent cash flow is the guaranteed cash flow that an investor would accept as a replacement for a risky cash flow of the same expected value.

Why is it important for a business to have positive expected cash flows at some point in time?

For a business to have value, it must have positive expected cash flows at some point, as negative cash flows indefinitely would render the business worthless.

What is the difference between valuing equity and valuing the entire business in a DCF model?

Valuing equity focuses on cash flows to equity investors after all debt payments, using the cost of equity as the discount rate. Valuing the entire business considers collective cash flows to both equity and debt holders, using the weighted average cost of capital as the discount rate.

Why is it crucial not to mix and match cash flows and discount rates in a valuation?

Mixing and matching cash flows and discount rates can lead to inconsistent and inaccurate valuations. It's essential to use the appropriate cash flows and discount rates that are internally consistent.

What is a financial balance sheet, and how does it differ from an accounting balance sheet?

A financial balance sheet focuses on investments in place and growth assets on the asset side, and debt and equity on the liability side. It differs from an accounting balance sheet by simplifying to these core elements and focusing on cash flow generating assets.

How does the concept of a financial balance sheet help in the valuation process?

The financial balance sheet helps in the valuation process by clarifying the distinction between valuing equity and the entire business, which in turn influences the choice of cash flows and discount rates used in the valuation.

What is the dividend discount model (DDM) and how does it relate to equity valuation?

The dividend discount model is a method of equity valuation that discounts expected future dividends back to their present value. It is a special case of the equity valuation model within the DCF framework.