We've covered valuing assets and comparing to market prices. Now let's tackle the most sophisticated approach: valuing businesses based on their cash-generating ability.
The income-based approach asks: how much cash will this business throw off over time?
Engagement Message
Why might future cash flows matter more than current assets?
Here's the core insight: investors buy businesses for the cash they'll generate in the future, not for what they own today.
A profitable software company with few assets might be worth millions because of its cash-generating potential.
Engagement Message
Can you think of a highly valuable company with relatively few physical assets?
The income approach focuses on cash flow, not accounting profit. Cash flow shows actual money coming in and going out.
A company might show $1 million profit but only generate $600,000 in cash due to equipment purchases and other investments.
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Why would cash flow differ from reported profits?
But here's the challenge: money received today is worth more than the same amount received next year. This is called the time value of money.
It’s like asking: Would you prefer to receive $100 now or wait five years to get the same $100?
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What makes money today more valuable than money in the future?
To handle this, we "discount" future cash flows back to today's value. A discount rate reflects the risk and time involved.
If we expect $110 next year with a 10% discount rate, today's value is $100 ($110 ÷ 1.10).
Engagement Message
Why do we divide by 1.10 to find today’s value?
The Discounted Cash Flow (DCF) method is the gold standard here. We project future cash flows for several years, then discount each year back to present value.
Add up all those present values, and you get today's business value.
Engagement Message
Which step seems toughest—forecasting cash flows or choosing the discount rate?
DCF works best for established businesses with predictable cash flows. Utilities, mature retailers, and subscription businesses are good candidates.
It struggles with startups or highly volatile businesses where cash flows are hard to predict reliably.
Engagement Message
What type of business would have the most predictable cash flows?
Type
Swipe Left or Right
Practice Question
Which businesses would be good candidates for DCF valuation versus poor candidates? Swipe each scenario left or right.
Labels
- Left Label: Good for DCF
- Right Label: Poor for DCF
Left Label Items
- Electric utility company with 20-year contracts
- Established grocery chain with steady customers
- Mature software company with subscription revenue
- Regional bank with consistent loan portfolio
Right Label Items
- Brand new biotech startup with no revenue
- Fashion retailer in declining mall locations
- Cryptocurrency mining operation
- Restaurant concept with only one location
