Over the years, I’ve spent a lot of time thinking about and working on business valuations across a broad range of transactions. Given that I’m a visual learner, I thought it would be helpful to illustrate my thoughts in a diagram with the valuation infographic.
Top Down vs. Bottom Up
As I look at the diagram, it logically flows from top to bottom, however, when building a financial model to value a business I usually think about it bottom up, and in an iterative way. I start in the bottom left corner of the diagram with historical financials, working my way up to the top, then back down again to build the forecast financials (and repeat the process again).
1. Historical Financials
The first place to start when valuing a business is usually with historical financial statements. The past matters a lot when performing a valuation, as it informs a view of the future and what’s realistically possible. The future, of course, is heavily influenced by what a company’s assets, management team, competition, and markets do going forward.
Examining the asset base in conjunction with the historical income statement will paint a picture of the business’ ability to generate a return on assets (“ROA”, net income divided by total assets), and most importantly, generate free cash flow (operating cash flow less capital expenditures). When evaluating a business’ assets, it’s important to look at both tangible (property, plant, equipment, etc.) and intangible assets (brands, customer lists, intellectual property, etc.).
3. Management Track-record
Assessing management can be quite challenging, especially if you don’t have the opportunity to meet them in person (which is the case for most retail investors). An easy way to evaluate their performance is to look back at historical guidance (if a public company) and measure it against results achieved.
Do you see a consistent trend of missing, meeting, or beating guidance? Measuring the track record, combined with in-person meetings to assess integrity, honesty, work ethic, etc., is the best way to decide whether you assign a “management premium” or “management discount” to the business.
What is the current state of competition in this industry? Are barriers to entry high or low, and how much pricing power does the company have? Answers to these types of questions (and others listed in the diagram above) will help shape your view of risk and the company’s ability to protect profits (which will be reflected in the forecast financials).
Warren Buffett and Charlie Munger are notorious for buying businesses that have wide moats around them, or more literally, have durable competitive advantages. Examples of companies with big moats around them include Google (Alphabet), railroad companies (infrastructure), Coca-Cola (its brand), and businesses with network effects, such as Facebook and Amazon. The wider the moat, the longer the company will be able to earn above-average profits, and the lower the risk of the investment. The inverse is true for companies with little to no moat.
6. Culture & Strategy
I group these two together because they are two of the main objectives of the CEO. Culture is critical as it drives the “Why” of an organization (see Simon Sinek) and motivates people to create a business that can change the world (even if in some small way).
Culture is also critical for driving company behavior such as honesty and integrity, which lowers the risk of the business. Next in importance is strategy (i.e., “strategy eats culture for breakfast”), as this will be critical in maintaining any durable competitive advantage that a company has or is attempting to gain/increase.
7. Future Assets
Based on the strategy of the business, what will the assets look like in the future? Will the company have to significantly invest to grow the asset base, and if so, what types of ROA will they earn? It’s important to think carefully about how much capital is required to sustain and grow the assets (based on the strategy) and how those assets will create value in the form of free cash flow generation. The details/inputs behind these assets will generate the “principles” or drivers of the financial model.
8. Forecast Financials
With a deep understanding of the industry, management (culture & strategy), and the business’ assets, it’s now possible to forecast future financial statements. A good financial model will dis-aggregate the various drivers of revenues, expenses, etc., and present them as inputs that can easily be changed. Depending on the industry or maturity of the business you may forecast out anywhere from 5 years to the end of an asset’s life.
9. Discount Rate
Once the financial forecast is in place, setting up the discounted cash flow (“DCF”) model is just simple mechanics in Excel. The most challenging and subjective part of the DCF model is determining what discount rate to use.
There are specific formulas you can use based on interest rates and relative volatility, but the essence of the discount rate is captured in most of the qualitative issues discussed above: stability of assets, durability of a moat, competence of management, risk of changes in competitive dynamics, and risk of changes in markets (e.g., government regulation).
Taking all of these into account will determine what discount rate you think is appropriate to account for the riskiness of the investment. To the extent you have risk-adjusted the cash flows directly in the model (for the risks discussed above), you don’t need to include those risks in the discount rate (i.e., a perfectly risk-adjusted cash flow forecast would be discounted at only the appropriate risk-free government treasury rate).
The net present value (“NPV”) of future cash flows gives you the value of the business, but how much are you willing to pay for it? Value investors will typically want to build in a margin of safety (say 20-30%) by paying less than the intrinsic value.
Other investors pay full value if they are willing to accept the discount rate as their internal rate of return (“IRR”). Investors typically look at comparable companies or past transactions (acquisitions) to see what other people are willing to pay for similar businesses (this adds an element of game theory or “greater fool theory” and moves away from intrinsic value).
This is how I think about valuation when building a financial model. I hope you found it insightful. I’m a visual learner and find it useful to organize mental models, like valuation, on paper. The key takeaway for me is that valuation is an iterative process – you really have to cycle through things like markets, competition, management, and assets multiple times with sensitivity and scenario analysis before you can build a reliable financial forecast and discount it back to today.
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