Valuation is the technique of estimating something’s worth. One of the secrets of the wealthy is that they know how to value income producing assets.

One way worth can be determined is at auction, where people bid and the highest bidder wins. But how do bidders know how much to bid and how much is too much?

The stock market is an auction where investors place bids: how much they are willing to pay for a stock, and asks: how much an investor is willing to sell for.

A share of stock is essentially a stream of future cash flows. Each investor is intuitively, or through analysis, estimating the present value of that stream of cash. The price of the stock at any given moment is the cumulative guesses of all those investors. It is based on The Wisdom of Crowds.

Private equity firms look for hidden value that the market investors may have overlooked.

The book Barbarians at the Gates tells the story of the conglomerate RJR Nabisco and its sale to the highest bidder. The buyout firm KKR ultimately won with the highest bid and bought the company. All the bidding groups went through lots of machinations to uncover the latent value of all the assets and divisions of RJR Nabisco.

Valuation of companies and assets can seem mysterious; where do you even begin? How can you value a startup that doesn’t even have any revenues yet?

There are essentially two basic techniques that are used in Valuation. One is ratio analysis of financial statements and the other is calculating the present value of future cash flows. Bankers, investors, financiers and entrepreneurs use these tools and techniques.

By ratio analysis we mean taking two numbers from financial statements and dividing one by the other. This technique is good for comparing different companies or the same company over time. This works well because ratios eliminate any relative size differences between the companies so you can compare apples to apples.

A particularly common valuation of companies done by ratio analysis is based on multiples of Earnings. The Price/Earnings ratio, P/E, is a way companies are compared based on their stock price relative to their earnings (earnings are also called net income or profit. They are all synonyms.) reported in the most recent year.

The earnings number is the bottom line of the Income Statement. This works well for comparing public companies that report these numbers. This technique can be used to value a private company by comparing its earnings and valuation range to an average of public reporting companies in similar industry sectors and markets. A similar ratio technique can be used as a valuation metric based on a multiple of revenues, the top line of the Income Statement.

You can also estimate the value of the Assets of a company from its Balance Sheet. Here you have to make adjustments for assets that have been depreciated and are reported as less valuable on the balance sheet, their book value, than their market value is. A company can be thought of as a bunch of income producing assets.

For more on financial statement analysis check out my book on the subject.

The second technique that is at the core of corporate finance is calculating the present value of future cash flows. That is a mouthful, but the basic gist is based on the time value of money and the idea that a company is essentially an entity that generates cash flows each year into the future. The trick is estimating those future cash flows and how much they might grow or shrink and what the risks are to realizing them.

This is where you have to polish your crystal ball and do some deep analysis of the business and its markets and competitors. All this information is compiled in a spreadsheet of financial projections and the bottom line future cash flows are discounted back to the present value at some determined discount rate that takes what similar investments are commanding in the market and any and all risks specific to this particular enterprise or asset.

This technique of calculating the present value of a stream of cash flows becomes essential when trying to value start-ups that have no revenue history or assets, or companies that are predicted to grow rapidly. In these cases you can’t rely on past performance and history in order to come up with a value based on P/E or existing assets.

Discounting future cash flows to their present value is the technique favored by investment bankers, venture capitalists, private equity, hedge funds, and savvy investors, banks and credit analysts, and CFOs. It’s not difficult to understand and you will be amazed how useful and powerful it can be.

Want More?

Check out my book Understanding Corporate Finance for the quickest way to use these tools ASAP.

If you are interested in a deeper dive into calculating the present value of future cash flow, check out my post NPV: The gold standard of financial decision making tools.

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