Valuations for Dummies

Ok.. So what exactly is finance and investment banking? Here I'll attempt to give the basics of what it is I'm learning in school and what I'm going to be doing upon graduation in investment banking...

A business (or an investment project) is essentially a money generating entity. How valuable a business is, is based on the amount of money the business will generate. Basically, the value of the sum of all the cash flows. Essentially we are just adding the cash the business will generate every year. The only problem is that there is a rate at we must discount the cash flows. This is because $1.00 today is not the same as $1.00 in 50 years. We need to take that into account.

Therefore, we must take the free cash flow that the business is generating every year. What number do we use for the free cash flows? It will be basically the cash that the firm is generating. The free cash flow will include the earnings of the business, adjusted for tax paid to the government, adjusted for expenses that accountants have subtracted from earnings, but not actually a cash outflow (depreciation and amortization), also have subtract the change in net working capital, and lastly, subtract the capital expenditures.

From there, we need to figure out the free cash flow every year. Obviously we can't tell the future, so we will try to predict what the future cash flows will be. We can look at the company's history and predict a growth rate, and we can use this growth rate to predict the next year's cash flow, the year after, and so forth.

Lastly, we can't simply just add all the cash flows together because $1.00 today is not the same as $1.00 in 50 years. I'm sure we would all agree that we would rather take the money today. Therefore, we have do, what you call "discount" the cash flows at a rate. How we discount something is to divide the cash flows by 1 plus an interest rate, and take it to the power of the number of years we are discounting it by. This interest rate, we call WACC, or the Weighted Average Cost of Capital. We are discounting the cash flows for the opportunity cost of the cash flows. Essentially, what it is saying is that there is an interest rate for debt (called the cost of debt), and there is an interest rate for equity (known as the cost of equity). Depending how the company is set up, (debt to equity ratio), we will have different weights for the interest rate for equity and debt. If we know the weights, and the cost of equity and debt, we can find the weighted average cost of capital.

After discounting every cash flow, we can then add them all together to get a firm value!

Using the discounted cash flow valuation, we can price how much the company is worth, and if another company is thinking of taking it over, we can find out the price to pay for that company.

On the investment side to value a stock, we find the value of the firm, and subtract the value of debt to get a total equity value. From there, we divide that by the number of shares, and we get a price per share for a specific company. This is what is quoted in the newspapers, when they say for example Apple is trading $110 per share.