INTRINSIC
VALUATION
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The Essence Of Intrinsic Value
• In intrinsic valuation, you value an asset based upon its fundamentals (or intrinsic
characteristics).
• For cash flow generating assets, the intrinsic value will be a function of the
magnitude of the expected cash flows on the asset over its lifetime and the
uncertainty about receiving those cash flows.
• Discounted cash flow (DCF) valuation is a tool for estimating intrinsic value, where the expected
value of an asset is written as the present value of the expected cash flows on the asset, with either
the cash flows or the discount rate adjusted to reflect the risk.
• Intrinsic valuation models predate the modern DCF model, since investors through the ages have
found ways to weight in expected cash flows into value.
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The Two Faces Of Discounted Cash Flow Valuation
• The value of a risky asset can be estimated by discounting the expected cash flows on the
asset over its life at a risk-adjusted discount rate:
𝐸(𝐶𝐹1 ) 𝐸(𝐶𝐹2 ) 𝐸(𝐶𝐹3 ) 𝐸(𝐶𝐹𝑛 )
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 = + + + ⋯ +
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑛
where the asset has an n-year life, E(CFt) is the expected cash flow in period t and r is a discount rate that
reflects the risk of the cash flows.
• Alternatively, we can replace the expected cash flows with the guaranteed cash flows we
would have accepted as an alternative (certainty equivalents) and discount these at the risk
free rate:
𝐶𝐸(𝐶𝐹1 ) 𝐶𝐸(𝐶𝐹2 ) 𝐶𝐸(𝐶𝐹3 ) 𝐶𝐸(𝐶𝐹𝑛 )
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 = + + + ⋯+
(1 + 𝑟𝑓 ) (1 + 𝑟𝑓 )2 (1 + 𝑟𝑓 )3 (1 + 𝑟𝑓 )𝑛
where CE(CFt) is the certainty equivalent of E(CFt) and rf is the risk free rate.
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Risk Adjusted Value: Two Basic Propositions
• The value of an asset is the risk-adjusted present value of the cash flows:
𝐸(𝐶𝐹1 ) 𝐸(𝐶𝐹2 ) 𝐸(𝐶𝐹3 ) 𝐸(𝐶𝐹𝑛 )
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 = + + + ⋯+
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑛
• The “IT” proposition: If IT does not affect the expected cash flows or the riskiness of the cash
flows, IT cannot affect value.
• The “DON’T BE A WUSS” proposition: Valuation requires that you make estimates of expected
cash flows in the future, not that you be right about those cashflows. So, uncertainty is not an excuse
for not making estimates.
• The “DUH” proposition: For an asset to have value, the expected cash flows have to be positive
some time over the life of the asset.
• The “DON’T FREAK OUT” proposition: A business with negative cash flows in the early years
can still be valuable if it has more than proportionate positive cash flows in the later years
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DCF Choices: Equity Valuation
Versus Firm Valuation
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Equity Valuation
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Firm Or Business Valuation
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Firm Value And Equity Value
• To get from firm value to equity value, which of the following would you need to
do?
a. Subtract out the value of long-term debt
b. Subtract out the value of all debt
c. Subtract the value of any debt that was included in the cost of capital calculation
d. Subtract out the value of all liabilities in the firm
• Doing so, will give you a value for the equity which is
a. greater than the value you would have got in an equity valuation
b. lesser than the value you would have got in an equity valuation
c. equal to the value you would have got in an equity valuation
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Cash Flows And Discount Rates
• Assume that you are analyzing a company with the following cashflows for the next five years.
Year CF to Equity Int Ex (1-t) CF to Firm
1 $50 $40 $90
2 $60 $40 $100
3 $68 $40 $108
4 $76.2 $40 $116.2
5 $83.49 $40 $123.49
Term Value $1603.0 $40 $2363.008
• Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax
rate for the firm is 50%.)
• The current market value of equity is $1,073 and the value of debt outstanding is $800.
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Equity Versus Firm Valuation
• Method 1: Discount CF to Equity at Cost of Equity to get value of equity
• Cost of Equity = 13.625%
• Value of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 + 76.2/1.136254 +
(83.49+1603)/1.136255 = $1073
• Method 2: Discount CF to Firm at Cost of Capital to get value of firm
• Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%
• Cost of Capital = 13.625% (1073/1873) + 5% (800/1873) = 9.94%
• PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 + (123.49+2363)/1.09945
= $1873
• Value of Equity = Value of Firm - Market Value of Debt = $ 1873 - $ 800 = $1073
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First Principle Of Valuation
• Discounting Consistency Principle: Never mix and match cash flows and
discount rates. If your cash flows are after debt payments, i.e., to equity, the
discount rate has to be the cost of equity. If your cash flows are pre-debt cash flows,
i.e., to the firm, the discount rate has to be the cost of capital.
• The Mismatch Effect: Mismatching cash flows to discount rates is deadly.
• Discounting cashflows after debt cash flows (equity cash flows) at the cost of capital will lead to
an upwardly biased estimate of the value of equity.
• Discounting pre-debt cashflows (cash flows to the firm) at the cost of equity will yield a
downward biased estimate of the value of the firm.
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The Effects Of Mismatching Cash Flows And
Discount Rates
• Error 1: Discount CF to Equity at Cost of Capital to get equity value
• PV of Equity = 50/1.0994 + 60/1.09942 + 68/1.09943 + 76.2/1.09944 + (83.49+1603)/1.09945 = $1248
• Value of equity is overstated by $175.
• Error 2: Discount CF to Firm at Cost of Equity to get firm value
• PV of Firm = 90/1.13625 + 100/1.136252 + 108/1.136253 + 116.2/1.136254 + (123.49+2363)/1.136255 =
$1613
• PV of Equity = $1612.86 - $800 = $813
• Value of Equity is understated by $ 260.
• Error 3: Discount CF to Firm at Cost of Equity, forget to subtract out debt, and get too
high a value for equity
• Value of Equity = $ 1613
• Value of Equity is overstated by $ 540 12
Generic DCF Valuation Model
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Same Ingredients, Different Approaches
Input Dividend Discount FCFE (Potential FCFF valuation model
Model dividend) discount
model
Cash flow Dividend FCFE = Cash flows FCFF = Cash flows
after taxes, before debt payments
reinvestment needs and but after reinvestment
debt cash flows and taxes
Expected growth In equity income and In equity income and In operating income and
dividends FCFF FCFF
Discount rate Cost of equity Cost of equity Cost of capital
Steady state When dividends grow When FCFF grow at When FCFF grow at
at constant rate forever constant rate forever constant rate forever
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Start Easy: The Dividend Discount Model
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Moving On Up: The “Potential Dividends” Or FCFE Model
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To Valuing The Entire Business: The FCFF Model
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DCF: The Process
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The Sequence
• Get a handle on the past and the cross-section: While the past is the past (and should have little
relevance in determining value), you can get clues about the future by looking at what your firm has
done in the past, and what other companies in the business are doing now.
• Risk and Discount Rates: Traditional financial theory (unfortunately) has put too much of a focus
on risk and discount rates, but they do remain ingredients in valuing a company.
• Estimate growth and future cash flows: This is where the rubber meets the road in valuation.
Estimating future cash flows is never easy, should not be mechanical and should be built around
your story.
• Apply Closure to cash flows: Since you cannot estimate cash flows forever, you need to find a way
to bring your valuation to closure.
• Tie up loose ends: Check to see what else in your business needs to be valued or adjusted for to get
to value per share.
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