How to Value a Company in 3 Easy Steps, How to Value a Business
- Valuing a Business Valuation Methods Capital Budgeting
Welcome back to our second part of Capital Budgeting, which is Valuing a Business.
Brought to you by MBABULLSHIT.COM.
Before this video, you should first understand present value, net present value, basic capital
budgeting, and the weighted average cost of capital, or the WACC.
If you don’t understand these concepts yet, I recommend that you watch my other free videos
on these topics above.
Let’s get down to it!
When we say valuing a business, we’re actually trying to answer the question “How much
is the business worth?”
If you remember, here is a store, an existing business.
Maybe you want to buy this store from its owner.
Before you buy from him, you have to find out how much is the business worth?
Here is where financial managers and accountants have different philosophies.
For most accountants, the way they would value a business is they look at the price of the
assets – shelves, building, uniform – and then they look at the price of the liabilities
or the debt (maybe they owe money to the bank) and then they come out with something called
“owner’s equity” and that’s how they value the business.
The amount of owner’s equity is how much the business is worth.
However, for financial managers, we don’t care about the asset value or the owner’s
equity.
We don’t care if this shelf costs $1M or if the business building is worth a lot, usually.
What we do care about is the present value of the free cash flows.
This is another way of saying how much the store actually earns.
If the store, for example, has $10,000 worth of shelf and equipment, but it only earns
$5 a year then the store is not worth much.
Even if the assets are worth a lot, the fact that it earns such a small amount means that
it’s a bad business and that it’s worth little.
Most financial managers put a heavier importance on the earnings of the business instead of
the assets of the business.
One way of representing these earnings is by looking at the free cash flow.
The way we value a business is we look at the present value of the free cash flow plus
the present value of its horizon value.
Don’t worry if you don’t understand these terms yet.
You will see in a while.
How to compute the “free cash flow” will be discussed in another video.
For this video, I will just give you the amount or the figure of this business’ free cash
flow so you can understand the concept quickly.
For example, this store has free cash flow earnings of:
Year 1: $10,000 Year 2: $12,000
Year 3: $11,000 Year 4: $13,000
This is given.
In more advanced problems, you would have to compute this yourself, but I will discuss
that in another video.
Let’s assume that these are the free cash flows of the store.
And then I give you the following information: Horizon year is Year 3, which means this (referring
to Year 3: $11,000).
You might be wondering what the heck is a horizon year?
Horizon means you look into the future.
However, most people make the mistake of thinking that the horizon year is the last year of
information that you are given in the problem.
Do not do that.
Year 4 is not the horizon year.
Usually, your professor will say that the horizon year is 1 year before the last year.
Remember to always read the problem carefully and look at what the professor says is the
horizon year.
In our case, it’s Year 3.
If you’re wondering why we need to know the horizon year, you’ll know in a short
time later.
I’ll show you why it is important.
And we know that the weighted average cost of capital is 10%.
In more advanced problems, you would have to compute the WACC by yourself.
If you don’t know how to compute this, you can watch the other video about WACC.
The other piece of information that is given is the estimated free cash flow long term
average growth of 5% per year.
For Year 4, Year 5, Year 6, Year 7, the free cash flow will grow 5% year.
It doesn’t mean that it will grow exactly 5% per year.
It just means that, on the average, it will grow 5% per year.
How do we compute or value the business?
We need to look at 2 formulas.
Remember, I said we have to look at the present value of the free cash flows.
To do that, we use this formula:
Don’t panic.
I know it looks scary and complicated, but I will show you how easy it is.