Valuing by cash flows: What it will bring in, brought back to today

What is a company worth? Financiers' answer fits in one idea: what it will bring in, brought back to today.

This method is called DCF: discounting future cash flows.

First building block: a euro tomorrow is worth less than a euro today. Because today, you could invest it.

With a rate of eight per cent, one hundred euros received in a year are worth ninety-two euros fifty-nine today.

Received in thirty years, the same one hundred euros are worth barely ten euros today. The distant future weighs little.

Second building block: which flows? Not accounting profit, but free cash flow.

It is the money left once wages, taxes and investments are paid. The money you can really take out.

A company can show profits and burn through its cash. Free cash flow is harder to dress up.

Third building block: at what rate to discount? It is the cost of capital, called the WACC.

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It mixes what debt costs and what shareholders demand. Debt can be read in the contracts. Shareholders' demands have to be estimated.

Hence the practitioners' saying: the WACC is half art, half science.

Say a company generating one hundred million euros of free cash flow, growing two per cent a year. Cost of capital: eight per cent.

You discount the first five years. Together, they are worth about four hundred and twenty-three million.

And after that? You do not forecast every year to infinity. You sum up all the rest in a single number: the terminal value.

Here, it is worth about one thousand two hundred and seventy-seven million, discounted. Total: one thousand seven hundred million.

Look at the share: the terminal value makes up seventy-five per cent of the result. That is common: often around seventy per cent, sometimes more.

Yet it is the most fragile part. It rests on growth and a rate assumed to last forever.

Lower the cost of capital by one point, to seven per cent: the value goes to two thousand and forty million. Twenty per cent more.

Raise it to nine per cent: about one thousand four hundred and fifty-seven million. One point of assumption, hundreds of millions apart.

So a DCF does not give a truth. It gives a range, and shows what the price depends on.

Its best use: start from the current price, and ask what it assumes. What growth must you believe to pay that price?

If the answer looks crazy, the price may be too.