Business Valuation
We will cover business valuation, equity valuation, and option evaluation. The ultimate goal is to develop a deeper understanding of corporate finance concepts with provide a toolset for how to value a broad range of assets.
There are multiple methods for trying to determine the value of an asset so it is important to learn the many ways companies handle this process. The first approach we will cover is known as Discounted Cash Flow Method (DCF) which is the most widely used cash flow valuation method. We will cover methods for modeling the effects of varying the input parameters within a DCF model to factor in uncertainty. A core parameter of DCF is the discount rate that is used to bring future dollars back to current value dollars. Figuring out what a company should use as a relevant discount rate involves using known data about a firm's capital structure. We will go into depth on how capital structure effects a project's value.
After discussing cash flow valuation methods, we will cover the use of comparables such as EV/EBITDA or P/E ratio. We will cover how these multiples are used for determining firm and equity value. Finally, we will end by covering some more specialized valuation tops such as the Fama-French approach to determining cost of equity, the use of hurdle rates in valuing private equity, modeling of leveraged buyouts, and the use of adjusted present value.
There are multiple methods for trying to determine the value of an asset so it is important to learn the many ways companies handle this process. The first approach we will cover is known as Discounted Cash Flow Method (DCF) which is the most widely used cash flow valuation method. We will cover methods for modeling the effects of varying the input parameters within a DCF model to factor in uncertainty. A core parameter of DCF is the discount rate that is used to bring future dollars back to current value dollars. Figuring out what a company should use as a relevant discount rate involves using known data about a firm's capital structure. We will go into depth on how capital structure effects a project's value.
After discussing cash flow valuation methods, we will cover the use of comparables such as EV/EBITDA or P/E ratio. We will cover how these multiples are used for determining firm and equity value. Finally, we will end by covering some more specialized valuation tops such as the Fama-French approach to determining cost of equity, the use of hurdle rates in valuing private equity, modeling of leveraged buyouts, and the use of adjusted present value.
Valuation basics, cash flows, and discount rates
What is Valuation?
The objective of most firms is to create wealth. To create wealth, we must manage investments that generate cash flows that are worth more than what was invested.
Our goal, as management, is to avoid making investment decisions based on incorrect or incomplete analysis. Valuation provides us a toolset to evaluate new investment opportunities. It is more than just discounting cash flows, we have to look at the whole story (market analysis, comparable multiples, strategic fit, etc.)
The objective of most firms is to create wealth. To create wealth, we must manage investments that generate cash flows that are worth more than what was invested.
Our goal, as management, is to avoid making investment decisions based on incorrect or incomplete analysis. Valuation provides us a toolset to evaluate new investment opportunities. It is more than just discounting cash flows, we have to look at the whole story (market analysis, comparable multiples, strategic fit, etc.)
Our Learning Objectives
- Objective #1: Determine how much a business is worth to you (intrinsic value)
- Valuation Method: Discounted Cash Flow (DCF)
- DCF is used to estimate intrinsic value based on expected future cash flows and risk.
- For Stable capital structure → Traditional WACC (Weighted Cost of Capital)
- For Changing capital structure → APV (Adjusted Present Value)
- Pros:
- Not tied to current stock price or market sentiment
- Based on business fundamentals: future cash flows and risk
- Helps avoid market mispricing and speculative bubbles
- Cons:
- Requires many assumptions precisely because it is not anchored to market prices
- Relies on long-term forecasts (often 10+ years into the future)
- Small errors in growth rates, margins, or discount rates compound over time and can lead to large valuation errors
- Objective #2: Determine how much you should expect to pay for a business
- Valuation Method: Comparable Multiples (Comps)
- Uses observed prices of similar companies or recent transactions to estimate value.
- Common multiples: P/E, EV/EBITDA, EV/Sales, etc.
- Assumes comparable firms are priced similarly by the market
- Uses observed prices of similar companies or recent transactions to estimate value.
- Pros:
- Tied directly to observed market prices
- Reflects current investor sentiment and transaction reality
- Simple, fast, and commonly used in practice
- Cons:
- Heavily dependent on current market conditions
- Can inherit market mispricing or bubbles
- “Fair value” is relative, not intrinsic
- Valuation Method: Comparable Multiples (Comps)
Investment Evaluation Process
- Phase I: Investment (Idea) Organization + Analysis
- Conduct a strategic analysis
- Estimate the investment's value
- Prepare an investment evaluation report + recommendation
- Phase II: Managerial Review + Recommendation
- Evaluate the investment's strategic assumptions
- Review the methods + assumptions in value (NPV) estimation
- Adjust for any estimation errors + formulate recommendation
- Phase III: Managerial Decision + Approval
- Make a decision (Yes or No, Now or Later)
- Seek final managerial and possibly board approval
Relevant Cash Flows (Incremental Cash Flows)
- These are cash flows directly generated by the investment, these could be:
- Projected revenues and costs of the new project
- Potential cannibalization (when the new project steals sales away from another product line. Example: Less people are likely to buy an iPhone 15(s) when the 16 comes out.)
- Sunk costs are not part of the incremental cash flows and should be ignored.
- Opportunity costs
- Include everything that is invested, including resources that might have other productive uses or market value (Land, Natural Resources, and Buildings)
- Time and Labor should also be included
Calculating a Project/Firm's Free Cash Flows (FCF)
NOTE: Notice that we don't ever subtract Interest Expense from EBIT. This is because we are interested in the cash generated by a project's assets BEFORE financing. Financing effects will be accounted for in later steps through the discount rate, not through the cash flow itself.
- Gross Profit =
- + Sales
- - Costs of Goods Sold (COGS)
- Earnings before Interest and Taxes (EBIT) =
- + Gross Profit
- - Operating Expense
- Net Operating Profit After Taxes (NOPAT) =
- + EBIT
- - Taxes
- Project Free Cash Flows =
- + NOPAT
- + Depreciation Expense (DA)
- - Capital Expenditures (CAPEX)
- - Changes in Net Working Capital (ΔNWC)
NOTE: Notice that we don't ever subtract Interest Expense from EBIT. This is because we are interested in the cash generated by a project's assets BEFORE financing. Financing effects will be accounted for in later steps through the discount rate, not through the cash flow itself.
Snow Cone Sales, Seasonality, and Risk (CAPM Intuition)
The image above shows monthly snow cone sales for two locations: Columbus, Texas and Columbus, Ohio. Although total annual sales are the same in both cities (1,000 snow cones), the pattern of sales over the year differs significantly.
Sales in Texas are relatively smooth and consistent throughout the year, while sales in Ohio are highly seasonal—concentrated in the summer months and very low during the winter.
If we think like lenders or investors, the Ohio location would likely face higher borrowing costs or worse loan terms. This is because its cash flows are less reliable throughout the year, making loan repayment more uncertain during off-season months. In contrast, the Texas location generates steadier cash flows, reducing repayment risk.
Connection to CAPM and Beta
This example illustrates a core idea behind the Capital Asset Pricing Model (CAPM)
If we treat Texas as the baseline or “market,” Ohio’s sales move in the same direction (both peak in summer and decline in winter), but Ohio’s swings are much larger. This means Ohio has higher covariance (also known as Theta) with the seasonal cycle, analogous to a higher beta in CAPM.
As a result:
Importantly, the higher required return is not because Ohio is more volatile in isolation, but because its performance is more sensitive to the underlying cycle.
The image above shows monthly snow cone sales for two locations: Columbus, Texas and Columbus, Ohio. Although total annual sales are the same in both cities (1,000 snow cones), the pattern of sales over the year differs significantly.
Sales in Texas are relatively smooth and consistent throughout the year, while sales in Ohio are highly seasonal—concentrated in the summer months and very low during the winter.
If we think like lenders or investors, the Ohio location would likely face higher borrowing costs or worse loan terms. This is because its cash flows are less reliable throughout the year, making loan repayment more uncertain during off-season months. In contrast, the Texas location generates steadier cash flows, reducing repayment risk.
Connection to CAPM and Beta
This example illustrates a core idea behind the Capital Asset Pricing Model (CAPM)
- Risk is not about total volatility or variability on its own.
- Risk is about covariance with the broader cycle (the “market”).
If we treat Texas as the baseline or “market,” Ohio’s sales move in the same direction (both peak in summer and decline in winter), but Ohio’s swings are much larger. This means Ohio has higher covariance (also known as Theta) with the seasonal cycle, analogous to a higher beta in CAPM.
As a result:
- Ohio requires a higher expected return
- Texas can accept a lower required return
Importantly, the higher required return is not because Ohio is more volatile in isolation, but because its performance is more sensitive to the underlying cycle.
How Capital Structure Effects Investor Demand
As we learned in accounting:
Consider the 2 capital structures:
As we learned in accounting:
- Assets = Debt + Equity
Consider the 2 capital structures:
- Unlevered Project - 0% Debt, 100% Equity
- Project - 20% Debt, 80% Equity
Between these two projects which is more risky? (2) Is more risky because the debt component must be paid back first before any of the equity holders can lay claim to the rest. Even for the same asset, as you increase debt % the equity holders will want a higher return.
There are 2 things that determine what your required returns have to be for your investors:
- The asset you are selling
- How you own it
How to Calculate Investor Demand?
The Weighted Average Cost of Capital (WACC) is a % that defines the average of the estimated rates of returns for a firm's interest-bearing debt (kd) and common equity (ke). The weights (w's) used for each source of funds are equal to the proportion in which funds are raise (so wd +we = 1). Notice the (1-T) part, that is the tax shield benefit (T = Tax Rate) companies get from having debt. But how do we calculate each of these variables?
Ways to calculate kd (Cost of Debt):
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Ways to calculate ke (Cost of Equity):
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If a firm were to own its assets fully in the form of debt (known as "Fully Levered") then we could simply use our Kd as the discount rate when discounting future cash flow back to the present value. Or if a firm owned all of its assets in the form of equity (known as "Fully Unlevered") then we could simply use Ke as our discount rate. However, when a firm owns its assets partially in the form of debt and equity, we must use the WACC as the discount rate.
Using the WAAC
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Givens:
So WAAC = 0.4(0.05)(1-0.2) + 0.6(0.14) = 10% |
Calculating Cost of Equity (Ke)
One of the most common ways to calculate Ke is to the Capital Pricing Model (CAPM) which uses the following equation:
One of the most common ways to calculate Ke is to the Capital Pricing Model (CAPM) which uses the following equation:
- Krf is the Risk Free Rate (This is typically the % return from US Treasury Bonds)
- Be (Equity Beta) is the covariance of the return of the firm and the market
- Km is the Market Rate of Return (This is typically the S&P 500 Average Rate of Return)
How do we figure out Be?
We can estimate Be by using historical return data. Plot the Firm's excess return (excess return = subtract out the risk free rate after calculating return) % vs. the S&P500's excess returns. The slope of these data points is the estimated Be.
Unlevering
Unlevering is about figuring out how risky a business really is, without letting debt confuse the picture.
Debt doesn’t change what a company’s products, customers, or operations do. What it does change is how risky the stock looks.
So when a company uses more debt:
Debt doesn’t change what a company’s products, customers, or operations do. What it does change is how risky the stock looks.
So when a company uses more debt:
- Equity looks riskier
- Equity beta goes up
Even if the business itself hasn’t changed at all.
3 Different Betas:
Why this matters
Unlever → get business risk → re-lever for the situation you care about.
- Equity beta: how risky the stock is (business risk plus debt risk)
- Debt beta: how risky the loans are (usually small)
- Asset beta: how risky the business itself is
Why this matters
- Two companies can look very different only because one uses more debt
- Projects don’t have debt — companies do
- If leverage changes, equity risk must change too
Unlever → get business risk → re-lever for the situation you care about.
Internal Rate of Return (IRR)
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Companies use WACC as their minimum acceptable return when deciding whether a project is worth doing. You can think of it as the company’s “cost to use money.” If a project can’t beat this rate, it’s not worth taking on.
IRR is the project’s own built-in return — it tells you what percentage return the project is expected to generate based on its future cash flows. So the decision is simple: If the project’s IRR is higher than the WACC, the project makes more money than it costs to fund → good project If the IRR is lower than the WACC, the project doesn’t earn enough to cover its cost → bad project |
Different Types of Free Cash Flows
There are 3 main types of free cash flows (FCF):
These cash flows are directly related:
There are 3 main types of free cash flows (FCF):
- Firm FCF (Cash Flow available to all Capital Providers)
- Creditor Cash Flows (Cash Flow available only to debt holders)
- Equity FCF (Cash Flow available only to equity holders)
These cash flows are directly related:
Start with Cash generated by the business as a whole. After paying back the debt holders, whatever remains belongs to the equity holders.
We can calculate Creditor Cash Flows by:
We can calculate Creditor Cash Flows by:
Let's breakdown each of these components:
- Interest Expense = (Debt) * (kd)
- Interest Tax Savings = (Interest Expense) * (Tax Rate)
- Principal Payment = Whatever amount goes into paying down debts
- New Debt Issues = How much ever new debt has been added