Price is what you pay, value is what you get – Warren Buffett
The value of a business is determined by the magnitude of its cash-flows, the risk or uncertainty of these cash flows and the expected level of growth in these cash flows. The price of a traded asset is determined by the demand and supply of the stock, market momentum and of course, the value of the stock is one of the inputs in the price.
The tools for estimating price and value are different.
To assign a value, we look at the business through first principles. We look at the business as an entity and see its cash-flow generating ability. To estimate it accurately, we use Discounted Cash Flow as an approach. We make assumptions about market and business fundamentals, growth, and expenses. We net out the cash-flows and use cost of capital which has the inherent risks of the business and discount it to present value.
To assign a price, we look at the market mood & momentum, notably how similar assets are priced at the market. We look at comparable assets, we look at the metric used to price them and use comparable ratios based on the evolution of our own company.
Whether we assign a value or price to a firm depends on if we are an investor or a trader. An investor looks at the bigger picture and focuses on value and growth, while traders normally focus on price and are judged if they can time the pricing movement.
Even though an investor might price your company, she would still want to see the financial projections on which the value is based.
Valuation based on DCF, then becomes imperative to understand your business.
It becomes a blueprint which allows you to think about all the aspects of the business – growth, expenses and profits, what are the inherent risks on a value-driven framework.
Unlike popular perception, DCF is not hard to build. At Samkhya, as we help startups and scale-ups with valuation, we realise that building a valuation is one of the most clarifying experiences for a company that a founder can have.
This is because it is a blueprint where the vastness of your vision matches the objectivity of the business.