A guide to the “right way” (discounted cash flow analysis), and why “everything is dumb right now.”

It’s astonishing just how much of human behavior can be ultimately traced back to somebody trying to increase the valuation of something.

When we see huge corporations like Facebook—I’m not ready to call them “Meta” yet 😅—marshal incomprehensible resources towards making ideas like “the metaverse” happen, that’s about valuation. When NFT collectors flock to projects that show signs of breaking out, that’s about valuation. When Twitter finally starts launching new features, or when an oil company wants to build a new pipeline, or when a local homeowner complains to their elected officials to stop a new apartment building from being built around the corner, these actions are all about valuation, too.

So much of the world revolves around valuation because valuation is the source of wealth. Valuation is why we have billionaires. Elon Musk’s $316,000,000,000 hasn’t come from his salary. Valuations are also how you can get headlines of billionaires “losing” hundreds of millions of dollars in one day (or vice versa). That money isn’t leaving a bank account, it vanishes as the value of the boxes these billionaires are investing in fluctuates.

The question is: where do valuations come from? Why are some assets considered more valuable than others? How do businesses, commodities, land, NFTs, options, derivatives, and currencies (crypto or otherwise) get reduced to a number?

There are a number of ways to answer this question. For instance, one way to learn how valuations are set is to learn how market-making mechanisms bring people with different opinions and incentives together to find a single “market price.” Another way is to understand how each individual in a market subjectively determines their own opinion about what an asset is worth. Although the price-finding mechanism of markets is fascinating to me, as an entrepreneur and investor I find the latter question to be more practical. And I am mostly interested in valuation of businesses, as opposed to other types of assets listed above. So this post is going to focus on how individuals can decide what they think a business is worth.

Business valuation is often treated as some sort of mystical black art. Especially in 2021, with valuations across the board going seemingly wild, it’s helpful to ground yourself in the fundamentals. That’s not to say we’re taking a conservative approach to valuation—you may well use the tools from this post to estimate sky-high valuations are actually a steal. Our goal isn’t to persuade you what you think the value of a thing should be. Instead, we’ll cover the basics of valuation methodology so you can understand it at a deeply intuitive level.

Let’s dive in!

Valuation and cash flow

Valuation is how much someone is willing to pay to own a piece of a business.

It may seem obvious, but it’s worth asking: why would anyone spend money to own some percentage of a business? What’s the “job to be done” of business ownership?

The two most common reasons are:

1. To make money. This can happen either through dividends, where the company distributes profits to owners, or by selling the stock later for a higher price than you paid to buy it.
2. To control the business. (Requires a majority ownership.) When you control a business, you can use it for all sorts of things. For example, if you control two businesses that complement each other, you can merge them together in a way that makes both businesses even more valuable than the sum of the parts. (Synergy!) Or maybe you just want to eliminate a competitor. Or maybe you’re just a fan of the business and want to be involved and get to call the shots, like sports team owners.

Of course, there are other reasons, like you might want to support the business if someone you care about runs it, or you believe in the positive impact the business could have on the world. But those typically need to be mixed in with the two above in order for someone to invest any substantial sum.

Since the value of controlling a business’s operations is pretty idiosyncratic to each specific situation, this guide will focus on the first point: making money.

To understand how investors decide how much they’re willing to pay to own a business if they’re not making a bid at control and just want to get a good return on their investment, it helps to eliminate all the complicated nuances of actual businesses and think of them as simple black boxes.

The black box metaphor

Think of a company as a little black box that spits out cash. Say one particular black box has been printing $5k each month for the last two years. It literally just connects to your bank account and adds $5k every month on the 1st.

How much would you pay to own that box?

To come up with a number, you might want to know the answers to a few questions:

• How certain is it that the box will continue to print $5k each month?
• How long has it been printing money?
• Did it start out printing $5k a month? Or did it gradually grow to get there?
• Is it still growing? Could it print out more than $5k/mo in the future?
• How many other people are trying to buy the box?
• What is the mechanism by which the box generates the $5k? How does it work?
• Do you have to do anything to keep the box functioning properly?

These are the same questions all investors—from VCs to BlackRock to Robinhood meme traders—are trying to answer when considering an investment. But I like the “black box” metaphor because it takes the complicated, abstract world of financial considerations and makes it extremely concrete and relatable. It forces you to think about the nature of cash flows, and it helps you understand why people ultimately buy stocks.

The terminal value for any business comes back to cash returned to shareholders in the form of dividends. When you buy AT&T, 8% of the value of your stock gets paid back to you every year. It only takes 12 years to earn the entire value of your stock back in dividend payments—and even then you still own the stock and can keep collecting dividends or sell it! The dividend is the “printing cash” function of the black box.

Now, many astute readers may be thinking, “But the fastest-growing and most popular stocks don’t pay dividends.” And it’s true, they don’t. But the reason people buy them today is still ultimately connected to the fact that they will probably pay dividends one day in the future.

To understand why, let’s return to the black box metaphor. Imagine you buy the box and you have the option to put money back into the machine, which, if you do it right, will improve the box’s functionality and enable it to spit out even more cash later. If you think you can do this you probably should, for two reasons. First, every time the business sends money to your bank account you get taxed on it. Second, when you reinvest profits back into a business productively, it can compound over time to create exponential growth. Which is great! But growing profits only matters if you eventually either start using those profits to pay yourself, or sell to someone else (who is buying because they might use those profits to start paying themselves).

The backstop of being able to actually earn income directly from owning a business is part of what supports stock prices. Some might call it “intrinsic value.” Even if every investor in the world decides they don’t like Facebook anymore, as long as it’s printing cash there’s a pretty concrete reason to buy it that doesn’t depend on investor opinion. This is why some people are worried about the long-term price of cryptocurrencies and NFTs, since in most cases there is no cash flow and therefore no dividend. (Although with NFTs specifically and smart contracts generally dividends are totally possible.)

The black box metaphor also helps us understand the importance of strategy. In the real world each business is a complex organism in an economic ecosystem. Survival is anything but guaranteed. Those who understand the lay of the land and how things work (a.k.a. business strategy) will do a better job picking businesses that are likely to keep printing lots of cash over time.

And in fact the length of time you expect the cash will continue flowing is a surprisingly central component of valuation.

Discounted cash flows

The gold standard for determining the value of a business is a method called “discounted cash flows” (DCF).

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