Finance
Valuation
What a business is worth: the cost of capital, then its cash flows discounted at that rate.
Start with the rate investors require, then value the business on the cash it should generate. The rate from the first tool can be sent straight into the second.
Cost of capital
The return investors expect for the risk they carry. Shareholders’ cost comes from the capital asset pricing model; lenders’ cost is cheaper after tax because interest is deductible. Weighted by market values, the two give the discount rate the DCF below uses.
- Cost of equity
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- Cost of debt after tax
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- Equity share of capital
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- Debt share of capital
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- Beta is measured from past share prices, so it is an estimate with its own error; for a private company, borrow the beta of listed peers and adjust for debt.
- Using market values matters: book equity usually understates what shareholders have at stake.
Discounted cash flow
What is a business worth today? Forecast its free cash flow, add a terminal value for everything after the forecast, and discount both at the cost of capital.
- PV of forecast cash flows
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- PV of terminal value
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- Terminal value share
- Implied FCF multiple at exit
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Rows change the cost of capital; columns change terminal growth. The centre cell is your case.
- A DCF is only as good as its forecast. Small changes in WACC or terminal growth move the answer a lot, which is what the sensitivity table is for.
- Terminal value uses the growing perpetuity (Gordon) formula on the year after the forecast.
Sources
- Sharpe, W. F. (1964). Capital asset prices: a theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425–442. (CAPM.)