Valuing a Business for the Long Haul.
Why a company's true value isn't a guess, but the sum of its future cash.
A young merchant in Chandni Chowk boasts that his new store will double its sales every single year forever. An older trader sits nearby, sipping tea. He knows that trees do not grow to the sky, and even the busiest market eventually runs out of new customers.
When you buy a share of a business, you are buying a share of its future cash. Valuing a business means estimating all the cash it will earn over its lifetime and translating that total amount into today's Rupees. This is the core of Discounted Cash Flow, or DCF.
For a simple, mature company like a local utility, we can assume it grows at a slow, steady rate forever. This is the single-stage Gordon Growth model. But most businesses do not grow in a straight line. They have a high-growth phase when they are young, followed by a mature phase when growth slows down.
To value these dynamic businesses, we use a two-stage DCF. We forecast the cash flows year-by-year during the high-growth years. Then, we calculate a single terminal value for all the years after that, assuming the business finally settles into a stable, permanent growth rate.
Gold rate versus making charges
When you buy gold jewellery, the true value is the weight of the raw gold. The making charges are extra. If a shopkeeper charges you a huge premium for a fancy design, you might feel good today, but you cannot recover that premium when you sell the gold. In investing, the company's actual cash flows are the raw gold. The extra growth you hope for is the design. If you pay a massive premium for growth that may not last, you are overpaying for making charges.
Why this matters
In a DCF model, the terminal value often makes up the vast majority of the company's total value. If you get this wrong, your entire calculation fails. Understanding this helps you see that investing is not about predicting next quarter's earnings, but about buying cash flows at a price that leaves a wide margin of safety.
Where people go wrong
- Projecting terminal growth higher than GDP growthA company cannot grow faster than the country's nominal GDP of 9.6% forever without eventually swallowing the entire economy.
- Using Gordon Growth for young startupsStartups have high initial growth that eventually slows down. A single-stage model fails to capture this shift.
- Double-counting growth in both stagesAssuming high growth in the first stage and then setting a high terminal growth rate leads to a massive valuation bubble.
Terminal value usually represents the majority of a company's total calculated value.
A company's permanent growth rate cannot exceed the nation's long-term economic growth rate.
Small adjustments to growth or discount rates will lead to massive changes in value.
We suffer from extrapolation bias, overestimating near-term high growth and projecting it too far into the future.