Single Stage FCFF Model
We now have a fair understanding of what the concepts of free cash flow to the firm is. We also know how to calculate this metric under various circumstances. It is now time to use this metric to arrive at the final valuation for a given firm which is the objective of the whole exercise. […]
Minimum Viable Product
We have already learned about the technique of proof of concept in the previous article. However, proof of concept isn’t the only technique that is used by entrepreneurs. There are other techniques that are frequently used as well. Minimum viable product is one of those techniques which is widely used by several entrepreneurs. In this […]
Return on Invested Capital (ROIC)
Return on Invested Capital (ROIC) is another popular metric that is used widely in financial analysis. The reason for its popularity is that like ROA, ROIC can be used by both equity and debt holders. Also, like ROA, it provides data about return to the company as a whole and is not affected by leverage. […]
Revenue Bonds and the Cash Trap Mechanism
Infrastructure projects last for many years. As a result, different sources of funding are used at different points of time in the project. As mentioned in the previous articles, most of the time, bank loans are used during the construction phase of the project. However, at the same time, bonds are the preferred source of […]
Series B Funding
In the previous articles, we have already learned about the seed funding stage as well as the series A funding stage. We know that entrepreneurs raise seed funding in order to be able to build the prototype of the product. After the prototype is in place, they raise Series A funding to build the actual […]
Equity valuation or the valuation of any asset is an art. Valuation is not a perfect science and there is no single correct answer to what the value of a security ought to be. Valuation is at best, an informed guess or an informed opinion. As such, when analysts use the term value, they might be using it to describe one of the many concepts that can fall under the umbrella term called “value”. As students, we must therefore be aware of the different types of concepts related to valuation. This article will explain in detail, the three most popular ones:
Market value is the easiest valuation concept to understand. It simply means the value of the company or an asset as denoted by its ongoing market price. As market prices vary wildly, so does the market value of any company or any asset which is listed on it.
Students tend to get confused trying to find out the difference between market valuation and market price. The truth is that there is no difference at all! The fundamental idea is that markets are efficient and at any point of time the prices reflected by the markets are an informed decision made by the market. The market price therefore is the same thing as market valuation and is based on the idea of efficient market hypothesis.
The concept of intrinsic value has been made famous by famous investors from value investing school like Warren Buffet, Benjamin Graham etc. In simple words, intrinsic value is that value which is imbibed in the asset. For instance, a machine may provide certain incremental benefits to its user over and above what manual labor could have. As such the machine provides incremental cash flows to the firm and has some amount of intrinsic value.
The value of a firm is nothing but the sum total of the value that will be provided by its assets over some selected time horizon. As such, just like the intrinsic value of an asset can be estimated, similarly the intrinsic value of an entire firm can also be estimated.
It is important to understand that the intrinsic value can only be accurately understood and calculated by someone who has an in-depth knowledge of the nature of the firm and the industry. Intrinsic value, calculated by analysts who are armchair experts is often way off the mark and grossly miscalculates what the correct value of the firm should be. Hence, while considering intrinsic value, one must compare and contrast the opinions of multiple analysts.
Intrinsic value looks at the value of a firm in isolation. It only considers that value which can be derived from incremental cash flows that will be produced by a firm. However, consider the case of an oligarch who faces only one competitor. This competitor is driving down the prices that the oligarch could otherwise charge from the customers. Hence, in such a case, if the oligarch can buy out the competitor, he will be able to eliminate the competition and become a monopolist. The benefits that will arise obviously cannot be computed using a simple discounted cash flow application. This may not be an ethical scenario. However, business has in the past witnessed these situations and in all likelihood will witness them in the future as well.
The point being made here is that sometimes corporations experience synergy when they combine their business. Hence, some competitors may be able and willing to pay more for an asset or a company if its fits well with their existing business. This valuation is called investment value. The recent acquisition of Whatsapp by Facebook is one such example of the use of investment value in real life scenarios.
It needs to be understood that investment value is subjective for each buyer. The synergies depend upon the current portfolio of assets that are owned by the acquirer and their strategic vision. Hence, Facebook, Yahoo, Google could have all pitched in for the acquisition of Whatsapp. However, the valuation that they arrive upon will depend upon the strategic fit of Whatsapp in their future plans. Since each company will have a different mix of assets and a different vision for the future. Hence, each company will arrive at a different valuation.
Once again, investment value is subjective. It does not depend upon the asset. Rather, it depends upon the buyer.
Hence, when the term value or value creation is used, it is possible that any one of these concepts is being referred to. An analyst or even a student for that matter must have a clear understanding regarding which measure of value is applicable in which context.
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Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
