Learn Discounted Cash Flow Valuation from Aswath Damodaran of the Stern School of Business at New York University
If you are at the beginning of your journey to learn business valuation, my recommendation is to start with an expert and learn from them. Aswatch Damodaran teaches business valuation courses at the Stern School of Business at New York University.
Professor Damodaran recorded a number of excellent videos about business valuation and posted them to YouTube. I highly recommend that you take the time to watch and listen to these videos as his approach to learning the art of valuation is excellent and rational.
Below are the videos in the order I would watch them:
This first video will center you on the purpose behind business valuation, the three big misconceptions about doing valuations, and the three methods of business valuation: Discounted Cash Flow (intrinsic value), Relative Valuation (comparable multiples), Option Pricing Method (commodity companies, highly levered troubled companies).
In this second video, Professor Damodaran builds a foundation around the concept of Intrinsic Value and how Discounted Cash Flow valuation ("DCF") is used only with cash flow generating assets. The value of such an asset is the present value of future cash flows. The three key elements are: forecasting cash flows, risk adjusting the cash flows, and choosing the appropriate discount rate.
This third video is about the "risk-free rate" that you use in DCF valuations. It will help you understand the importance of this rate, and the proper way to use it.
This fourth session by Professor Damodaran is focused on the "equity risk premium" used in a DCF.
This fifth session is a continuation of inputs into a DCF calculation and is all about what relative risk really is and whether or not Beta should be used as a metric for measuring relative risk.
This sixth session discusses debt and the cost of debt, and how to calculate the "cost of capital" that will be used as ingredients in a DCF.
Now that you have the key ingredients in the discount rate (cost of capital) you will be using in a DCF, this next video discusses how to estimate the future cash flows of a business.
Now the key question: "How much will the company grow cash flow in the future?" This seventh episode by the Professor discusses the proper way to estimate future growth.
The ninth session on the DCF is about the terminal value. The terminal value represents all the far-in-the-future remaining cash flows of a company.
Session ten by Professor Damodaran is about how to enhance the value of the business in the future. The four ways are:
- Increase cash flows from existing assets
- Increase the growth rate in the future
- Reduce the risk and therefore the discount rate
- You "push off" the date of closure of the business
The eleventh session is about any and all other considerations when doing a DCF calculation such as including cash and marketable securities, cross holdings in other companies, other assets, and the debt that will subtract from the valuation in order to get the value of equity.
In the twelfth session, the professor discusses a few more considerations related to acquisitions a company has recently made.
The final session in this series about the DCF valuation method is about three items that can reduce the equity value of the company you are valuing: distress, dilution, and illiquidity.
If you have watched all of these videos from beginning to end, you will have a well-grounded understanding of the kinds of ingredients you will need to gather to cook up a DCF valuation.
The next step for you is to pick a business on which to do your first DCF valuation. I recommend starting with a simple business is easy to understand, such as the WD-40 company (NASD:WDFC). Re-watch the videos from session number two above, and complete each step as you watch each. Hit pause often, and don't skimp on the work.
Once you have a gone through all of the steps, you should know how much WD-40 is worth as a business overall, and how much the equity component is worth. Now look at the stock price to see what it is selling for in the open market. Decide what bucket the current price falls in to:
- Under-valued and by how much
- Fairly valued
- Over-priced and by how much
If you find that the stock price under-values the equity, the difference between the price you calculated it is worth and the price the market is selling it for is the "margin of safety." The larger the margin of safety, the greater the possibility of a profitable purchase of that business.