Understanding the Basics of Intrinsic Value

The chapter opens with a discussion on the two different approaches to valuation. Aswath Damodaran, a professor of finance at New York University's Stern School of Business, explains the two methods are valuing the entire business or focusing on just the equity investors. He emphasizes that both methods can yield the same value for the equity, but it's a matter of understanding which approach is easier to implement.

The Ingredients of Valuation

Damodaran then delves into the key components of valuation, starting with cash flows to equity. He outlines the process of computing free cash flow to equity, stating that it is a measure of what cash is left over after a company has met all its financial obligations.

He covers the realized and potential dividends, discussing how to adjust dividends to account for stock buybacks and potential dividends. He also explains how to calculate free cash flow to equity using net income, adding back non-cash charges, and accounting for capital expenditures and changes in working capital.

Damodaran further expands this by explaining how to compute free cash flow to the firm, which accounts for cash flows to both equity and debt claim holders. He highlights the importance of understanding how these cash flows can impact the valuation of a company.

Assessing Risk and Required Rate of Return

Moving on to risk assessment, Damodaran emphasizes the need to understand how risk is measured and how it impacts the required rate of return. He details the process of estimating the risk-free rate, discussing the considerations involved in determining a default-free entity when using government bonds as the risk-free rate.

The discussion then turns to the equity risk premium, emphasizing the need to consider the dynamic nature of this measure. Damodaran presents his approach of using the implied equity risk premium, which he argues provides a more forward-looking and dynamic estimate compared to the traditional historical risk premium.

He then outlines his method of estimating beta or betas, explaining his preference for a bottom-up beta approach, which involves looking at the betas of companies in the same industry.

Valuing Company Cash Flows

The chapter continues with a comprehensive breakdown of the valuation process for a specific company, Craft HS Corporation. Damodaran walks through the steps of forecasting the company's free cash flows, taking into account historical data, industry dynamics, and the company's operational and financial characteristics.

He discusses the importance of assessing growth, profitability, and reinvestment when forecasting cash flows and highlights the need to consider the company's life cycle and industry dynamics in making these projections.

The session concludes with the computation of the company's cost of capital, factoring in the cost of equity and cost of debt, and the determination of the terminal value. Damodaran then demonstrates the calculation of the company's intrinsic value per share and provides insights into comparing this value with the market price of the stock.

Conclusion

In summary, this session provides a comprehensive overview of the key concepts involved in the valuation of a company's cash flows and intrinsic value. Aswath Damodaran's detailed explanations and practical examples offer valuable insights into the intricacies of equity valuation and underscore the importance of considering various factors when assessing the value of a company.