Now that we have the introduction to valuation out of the way (and the random thoughts on mean reversion and R&D capitalization), it’s time to move onto the concept of intrinsic value. Intrinsic value is a concept that is thrown around a lot in finance, especially the value investing niche. However, while the concept is thrown around like a frat bro yelling out YOLO every 5 minutes, it’s never clearly defined for those who are new to the game. Hopefully this session clarifies it a little bit and gives you an idea of what intrinsic value means and how you start going about calculating it. The actual calculating will come in later sessions and this one will just give you an idea of how to go about setting up the framework to estimating intrinsic value later on.
Building on the concept of Intrinsic Valuation and Discounted Cash Flows we touched on in the first section, I’ll talk about my big takeaways.
First, it helps to break the balance sheet away from the accounting balance sheet and look at it from the perspective of a Financial Balance Sheet:
Breaking down the balance sheet this way allows you to more easily value the business, either purely for equity holders or for the entire firm.
When it comes to using Discounted Cash Flows, you need to decide whether you are valuing the entire business (Firm Valuation) or whether you are just valuing the equity claim in the business (Equity Valuation).
What’s the difference? If you are using Equity Valuation, you are only interested in the cash flows left over for owners of the company after all debt-holders have been paid.
For Equity Valuation, your discount rate would have to reflect the rate at which equity investors need to make given the risk of that equity. The riskier the equity, the higher the rate of return is going to be. Cash flows to equity, discounted back at that rate of return – the cost of equity – is the value of equity in the business. The discount rate in this model reflects only the cost of raising equity financing.
On the other hand, if you are using Firm Valuation, you are interested in the cash flows generated by the total assets in the business.
For Firm Valuation, you are looking at the collective cash flows for both equity investors and debt-holders. You need both the Cost of Equity and the Cost of Debt, which combined is the Cost of Capital, in order to value the cash flows to the entire firm.
Here is what a generic Discounted Cash Flow model would look like for both Equity and Firm Valuation methods:
If you choose to use the Equity Valuation model, you require the Cost of Equity for your Discount Rate and you will be using Net Income.
If you choose to use the Firm Valuation model, you require the Cost of Capital for your Discount Rate and you will be using Operating Income.