Business Valuation
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
There's no single correct way to value a company — you can measure it by the cash it generates, or by financial health metrics like earnings per share. Which one you use is a matter of what question you're actually trying to answer.
What is market capitalization?
Market capitalization is what the stock market says a company is worth. You find it by multiplying the price per share by the number of shares outstanding — it's a live, market-driven number, not one derived from the company's own projections.
How do you value a company by discounted cash flow?
Say you're deciding whether to buy Benny's Barbecue, and you want to value it by the cash it's projected to generate over the next five years:
| Year | Undiscounted Cash Flow | Discounted Cash Flow (at 7%) |
|---|---|---|
| 1 | $200,000 | $186,916 |
| 2 | $180,000 | $157,219 |
| 3 | $150,000 | $122,445 |
| 4 | $130,000 | $99,176 |
| 5 | $110,000 | $78,428 |
| Total | $770,000 | $644,184 |
The discounted column is the one that actually matters. The undiscounted total ignores the fact that a dollar five years from now isn't worth as much as a dollar today — it doesn't account for the return you require on your investment.
Say you want a 7% return. Each year's cash flow gets divided by 1.07 raised to that year's power:
Year 2: $180,000 ÷ 1.07² = $157,219
...and so on through year 5. Sum the discounted column and you get $644,184 — that's what Benny's Barbecue's future cash flows are actually worth to you today, at your required rate of return.
Discounting isn't optional if the cash flows span multiple years. Comparing an undiscounted total to a purchase price ignores the time value of money entirely; the discounted total is the number that should actually inform whether the deal is worth it.
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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 98 on BEC. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.
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.