The value equation is based on the Gordon Growth (or dividend discount) model. Although somewhat simplistic in nature, most discussions regarding value can be framed by the relationships and interaction of cash flows, growth and risk.

Cash Flow

There are three general approaches to valuing an investment: cost, income, and market. Each represent a version of the definition of value taught in finance class: “value = the present value of future cash flows”.

For the discounted cash flow method (an income approach), cash flows consist of projections of future revenue and expenses. Key inputs can vary based on the stage of life and industry. In high growth scenarios, proportionately higher infrastructure and hiring costs may be required to support revenue growth anticipated. Certain industries may include high levels of deferred revenue or inventory which can result in significant working capital changes. Projected cash flows should also consider future financing costs including future equity or debt funding requirements.

When using market multiples, cash flows are represented by revenue, EBITDA (earnings before interest, taxes, depreciation and amortization), earnings, or others (e.g., funds from operations, EBITDA less capital expenditures, net operating income).

By constructing projections of future cash flows with the right mix of internally generated data and external support, the selection of risks becomes less dependent upon adjustments for company specific risk and more dependent upon the source of the industry risk component applied.

Risks

Risk is defined in the Oxford Dictionary as a situation involving exposure to danger. Economic Times indicates that risk implies future uncertainty about deviation from expected earnings or expected outcome. In the valuation of a business, asset, or liability, risk is captured through the selection of the guideline companies and market multiples in the market approach and the rates of return applied in the income approach. Support for these selections is based on a comparison of the valuation subject and the data captured in terms of size, growth, profitability, leverage, addressable market, customer base (and many other factors). If four guideline companies were exactly the same as the valuation subject, we could just choose the average multiple. Unfortunately, that’s never the case.

Growth In the Value Equation, growth represents the expected long-term changes to future cash flows from regional and global factors. The input is specifically identified when constructing a discounted cash flow model that includes a terminal value based on the Gordon Growth or H model methods. Inflation is typically the reference point for this input, however, other factors may also be influential. For instance, if population in a key addressable service area is higher than an identical company in a different market, the value associated with the higher growth market should be greater. Access to the internet as well as the income changes for a significant demographic of potential customers are other examples of factors that may influence this selection.