

Here is the Valuation 101 of how investment bankers determine if a share is currently undervalued or overvalued. We use a piece of financial economics called a discounted cash flow (DCF) model. This is a key part of corporate finance. Now value does not always equal price – but as the Benjamin Graham quote goes, “In the short-term the market is a voting machine and in the long-term a weighing machine”.
The DCF is the primary method in corporate finance theory for calculating value. In corporate finance – value is a DCF
The genius part of the DCF is that it only requires two inputs:
That sounds really simple – but there is a lot of work that goes into making assessments of each of those inputs. For example:
However, I am going to walk through a really simply example – a cartoon valuation. An investment banker would never use this level of simplification – but I am trying to illustrate the process.
We are going to use Telecom New Zealand [NZX: TEL] as our example. Telecom’s current share price as at 25 October 2013 is $2.32 – how do we get to an assessment of whether that is over or under-valued?
First – estimate the future post-tax cash flows of the business:
TABLE – EBITDA to Post-Tax Free Cash Flow
Cash flow component |
Amount |
EBITDA |
$1,000 million |
less: Capital Expenditure |
$450 million |
less: Tax |
$150 million |
Free Cash Flow |
$400 million |
Yes these are a simplification – a cartoon valuation remember.
Second – estimate the post-tax discount rate:
The calculation where PTFCF equals Post-Tax Free Cash Flows:
This gives an Enterprise Value (EV) of $5.0 billion. From the EV we deduct Net Debt [Long-term borrowings ($976 million) less Cash ($118 million)] of $858 million. EV less Net Debt gives us the value of the Equity in Telecom of $4.142 billion (equivalent of the market capitalisation). Then we divide the value of the equity by the number of shares on issue (1.822 billion) to get our calculation of the value of Telecom’s shares of $2.27 – very close to the current $2.32 share price.
TABLE – EV calculation to Share Price
Enterprise Value (EV) |
$5,000 million |
less: Net Debt |
$858 million |
Equity Value |
$4,142 million |
Shares on Issue |
1,822 million |
Value per share |
$2.27 |
In a really basic way – that is how investment bankers do a valuation.
Disclaimer: Intended for educational use only. See a financial advisor before making any investment decisions.
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