Value a business like a professional investment banker

“In investing you get what you don’t pay for”

-John C. Bogle-

The stock market is giant distraction from the business of investing. It’s amusing to see daily price fluctuations of stock prices. At the same time , it is strikingly absurd that a company can be worth less one minute and more the next. This is a speculators game, but we have much to thank them for. They provide liquidity in the markets, allowing swift entry and exit from the market. But for long-term investors constantly trading a company’s stock is not in their best interests.

Its strange how a concept so important such as capitalism is discussed so little growing up. The surface of this topic is not even scratched in schools. Millions of businesses large and small are key to the prosperity of a nation. Investors provide businesses with capital to launch new companies who in turn provide employment. If there were no businesses in the world, our economy would collapse and there would be no jobs for anybody.

The absence of such knowledge for the majority of people is disappointing. Young people are becoming more motivated to invest. But not in the good way. Some new investors lately are simply gambling by taking stock tips from online forums, such as reddit or copy trading. While some may have made it out unscathed, there are likely more that have not fared so well. It is safe to assume, little to not analysis had been done if you are buying stocks based on recommendations.

The stock market does not always price businesses correctly. And prices often do not reflect its value. So here’s the million dollar question. How much should I pay for a company and how do I know? As intelligent investors, we are aware that no matter how good a business is, paying too dear a price for it will result in a bad investment.

Discounted cash flow model (Unlevered Free Cash Flow)

In my previous post on “how to value a business on the stock market“, I explain my method of valuing a business. Not much has changed except, back then, I used levered free cash flow (LFCF) for the analysis. In my updated version, I adopted the unlevered free cash flow method.

Levered free cash flow is the amount of cash a business has after it has met its financial obligations. Whereas unlevered free cash flow (UFCF) is the money a business has before paying its financial obligations.

In simple terms it is the gross free cash flow generated by a company. UFCF is preferred when undertaking a DCF analysis as it indicates how much a business has to expand and is a better measure.

I have to give credit to this upgraded version to my simpler DCF model I was using to Ben, a former investment banker at J.P Morgan. He shares his experience and knowledge on his YouTube channel “rareliquid“.

Which is where I found the content he posted on how Investment Bankers performed their DCF. I recommend checking out his account as he shares valuable insight on Tech companies, crypto and investment (I want to note that this is not a paid sponsored post, I sincerely think his content is valuable).

It took countless hours to write the formula for the excel spreadsheet as he does not go through how he did it. But after days of googling (NASDAQ:GOOGL), I managed to complete it. Hardwork does pay off!

How to Value a Business Using a Discounted Cash Flow

This upgraded DCF model (available here) allows me to perform an analysis based on three different scenarios. First one being the base case (the most likely scenario), second a conservative case and lastly an optimistic case. For me personally the conservative case has greater weight in my decision making.

The reason being that there is a greater margin of safety if I am able to purchase at the conservative price as there is a greater upside. The downside to opting for the conservative case is that you may possibly be overvaluing the company when it is actually undervalued. There is no win-win situation, but this method has served me well.

At the bottom of the spreadsheet there is a sensitivity table that I like to analyse aswell. It presents a range of values based on different WACC and terminal growth rates, giving you a better overview of how different rates can affect the price of the stock. I use this as a guidance to my decision making aswell.

There are, however, limitations to a DCF being that they are based on assumptions. The game of assuming is you’re likely going to be wrong. Therefore, your assumptions of a company’s projected performance and is most likely going to be – wrong. Two investors presented with the same information will always come up with different intrinsic values. You could be wrong, they could be wrong or you both could be wrong.

What the DCF can do for you

The DCF analysis aims to value a business based on the total value of the cash flow a business is able to generate in the future. And then discounting the total back to its net present value, arriving at fair value to equity (intrinsic value).

It is however not a perfect tool for valuation. You can think of it as a guide that provides you with a quantifiable value of a business. While not be perfect it prevents you from blindly purchasing individual stocks at any price. I recommend all investors to have the DCF in their investing arsenal.

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