Business Valuation

In this chapter, we delve into the fascinating world of business valuation, a cornerstone in understanding how businesses function and grow. As we explore the realms of dividends, capital asset pricing, and derivatives, we’ll learn the models that analysts use to assess a company’s financial health.

Starting with dividend valuation, we’ll break down how companies can be evaluated based on their constant or growth dividends, using practical examples for clarity.

Next, we’ll delve into the Capital Asset Pricing Model (CAPM), a cornerstone of modern financial theory that calculates the expected return on an investment.

Finally, we shift gears and delve into the realm of derivatives, specifically focusing on stock options.

There are different methods for valuing a company. Do we want to value it by the cash inflows it generates? Or do we want to measure it by the company’s financial health (e.g., earnings per share)? There is no single correct method for valuation, it’s a matter of preference. 

What is a company’s market capitalization? Market capitalization is what the stock market says a company is worth. To find a company’s market capitalization, you multiply the price per share by the number of shares outstanding.

Example – Cash Flow Valuation 

Let’s first talk about an example where we’re trying to determine whether or not we want to buy Benny’s Barbecue. We’re going to measure the value of Benny’s Barbecue by the cash inflows it’s going to generate.

Benny’s Barbecue

 Cash Flow Undiscounted                                                     Cash Flow Discounted

 Year 1 - $200,000                                                                  Year 1 - $186,916

 Year 2 - $180,000                                                                  Year 2 - $157,219

 Year 3 - $150,000                                                                   Year 3 - $122,445

 Year 4 - $130,000                                                                   Year 4 - $99,176

 Year 5 - $110,000                                                                    Year 5 - $78,428

              $770,000                                                                                 $644,184

Would we want to focus more on the undiscounted cash flow or on the discounted cash flow? The more relevant information is the discounted cash flow because the undiscounted amount does not take into consideration our required rate of return. Imagine we want to earn a 7% return on this investment.

We need to turn the year 1 $200,000 undiscounted cash flow into the $186,916 discounted cash flow ($200,000 / 1.07). For year 2, we would divide the $180,000 undiscounted cash flow by 1.07² The total discounted cash flows are $644,184.