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Start for freeUnderstanding Business Valuation Fundamentals
When it comes to assessing the value of a business, the process can be complex and multifaceted. Financial managers play a crucial role in this endeavor, especially when they need to take a stand on the entire business's worth. By treating the company as one large project, the focus shifts to the company's cash flows, which are the lifeblood of valuation.
The Role of Cash Flows in Valuation
The valuation of a business revolves around its ability to generate cash flows. These cash flows must be projected and discounted back to their present value, but there are a few critical points to remember:
- Weighted Average Cost of Capital (WACC): When discounting cash flows at the WACC, interest should not be deducted. Taxes should be calculated as if the company were financed equally across debt and equity.
- Terminal Value Importance: While companies are assumed to continue indefinitely, financial managers typically focus on a medium-term horizon. The terminal value, which represents the present value of all subsequent cash flows beyond this horizon, often accounts for the majority of the business's value.
- Equity Valuation: To value the company's equity, the common stock, it's essential to subtract the value of outstanding debts from the total valuation.
Calculating Free Cash Flow
The formula for calculating the free cash flow is key to understanding business valuation:
- Free Cash Flow = Profit After Tax + Depreciation - Investment in Fixed Asset - Investment in Working Capital
This formula allows us to determine the cash flow generated by operations after accounting for cash investments.
Present Value of Medium-Term Cash Flows and Terminal Value
Valuation is not just about the near future but also the long term. Here's how it's done:
- Estimate cash flows up to a medium-term horizon, such as year 10.
- Assume that the cash flow generated in the horizon year will continue indefinitely.
- Calculate the present value of these constant streams of cash flows to determine the terminal value.
A Real-World Example: Rio Corporation
To illustrate this process, let's take a hypothetical example of Rio Corporation. After deducting costs, we determine the EBIT, calculate taxes, and consider depreciation to find the profit before and after tax. From there, we account for investments in fixed assets and working capital to derive the free cash flow. Once we have the free cash flow from year one to year six, we determine the present value of these flows and add the horizon value to obtain the company's present value.
Growth Considerations
In calculating the horizon value, we assume an annual growth rate post-horizon year, such as 3%. The present value formula for a constant growth model is then applied:
- Present Value of Horizon Value = Cash Flow / (Required Rate of Return - Growth Rate)
By summing up the present value of medium-term cash flows and the present value of the terminal value, we arrive at the total present value of the corporation.
Conclusion
Business valuation is a critical skill for financial managers, involving a deep understanding of cash flows, WACC, and the concept of terminal value. Through this methodical approach, one can determine the worth of a company, both in the medium term and in perpetuity. As complex as it may seem, these principles lay the foundation for accurate and strategic financial planning.
Stay tuned for the next video where we will delve into the 'tricks of the trade' and provide practical examples to further enhance your understanding of business valuation.
For a more detailed explanation and examples, watch the full video here.
