The value of a company equals the discounted present value of all future free cash flows. Here is the formula for calculating value (noting that the growth rate must be less than the discount rate for the formula to work):
V = Value
FCF = Free Cash Flows
k = discount rate
g = growth rate
In words, the value of the company is the free cash flow projected for the next year, divided by the difference between the discount rate and the growth rate.
| Name | Formula | Definition | |
|---|---|---|---|
| p | Net Profit Margin | After Tax Operating Profits ÷ Sales | Net profit margin shows how much of each dollar collected as revenue translates into profit, as a percentage. It is an important indicator of a company’s financial health; however, low profit margin doesn’t always mean low profits. Walmart, for example, has a profit margin of only 2.0%, but is #1 on Fortune 500’s annual list of most profitable companies. Apple is 4th on the list with a profit margin of 21.1%. |
| a | Asset Intensity | Total Net Operating Assets ÷ Sales | A company with high asset intensity requires a signification amount of money and other financial resources to produce a good or service. For example, companies in the utilities, railroad, and construction industries are asset intensive because they typically require land, large buildings, plants, equipment, and vehicles. |
| g | Growth Rate in Sales | (End Sales – Beginning Sales) ÷ Beginning Sales | The growth rate of sales is used to analyze how much a company’s sales have changed over a period of time and might be used to make predictions about future performance. Growth rates tend to vary by industry; for example, tech companies typically experience higher growth rates than companies in mature industries, like retail. |
| k | Discount Rate | An interest rate used to calculate the present value for a stream of future cash flows and reflects systematic risk, inflation, and risk free rates in the economy. |
Low asset intensity and high profit margins will generate the highest value for a company.
Great business models have high profit margins, low asset intensity, high growth, and low discount rates. Companies that can improve their business model (e.g., lower their asset intensity without sacrificing growth or profitability) can increase value.
Free Cash Flow is defined as:
After-Tax Operating Profits
Plus
Depreciation
Less
Change in Net Operating Working Capital
Less
Capital Expenditures
External Financing Deficit/Surplus is defined as:
Free Cash Flow
Less
Interest * (1 - tax rate)
Plus
Proceeds of Sale of Excess Assets
Plus
Change in Short-term Debt
Plus
Change in Long-term Debt