How to value a stock: fair value, assumptions and a worked example

Keep enterprise value and equity value separate#

Enterprise-value methods value the operating business before allocating value among financing claims. Equity methods value the common shareholders' claim more directly. Mixing cash flow before debt payments with an equity-only discount rate can produce an inconsistent calculation.

Debt, cash, preferred securities, minority interests and other claims may need adjustments, depending on the method. We will start with a business whose only financing adjustment is net debt.

Calculate the present value of future cash#

Suppose a business generates $10.000 million of cash flow available to all capital providers at each year end for five years, with no remaining value after that. Using a 10% annual discount rate gives the following calculation.

The formula for each year is cash flow divided by 1.10 raised to the year number. Using unrounded values, the total operating value is $37.908 million. Rounded table rows may not add exactly to the rounded total.

If net debt is $5.000 million and there are 10.000 million common shares, equity value under these assumptions is $32.908 million, or about $3.291 per share. The calculation excludes other claims, taxes on distributions and transaction costs.

Test how the assumptions change the result#

Keep the same $10 million annual cash flows for five years, no value afterwards, $5 million net debt and 10 million shares. Change only the discount rate:

The operating cash flows have not improved in the 8% case. A lower required return assigns more present value to the same future money. Choose and explain a rate appropriate to the cash flow and its risk; selecting 8% simply because the result is higher does not support that assumption.

Our original model also assumes the business has no remaining value after year five. To examine a continuing business, keep the first five cash flows and the 10% discount rate, but suppose cash flow then grows by 2% a year forever. Year-six cash flow is $10.2 million. A perpetual-growth terminal value at the end of year five is $10.2 million divided by (10% minus 2%), or $127.5 million. The NYU valuation lectures explain cash-flow valuation and terminal assumptions.

That $127.5 million is a year-five value. Discount it back five years at 10% to get $79.167 million today. Add it to the first five cash flows' $37.908 million present value for $117.075 million operating value. Subtract the same $5 million net debt and divide by the same 10 million shares: about $11.208 per share, using unrounded calculations.

The move from $3.291 to $11.208 comes from assuming a continuing business with that future cash generation. It is not evidence that the shares should be worth $11.208. Sustaining the cash flows may require reinvestment, and the 2% perpetual growth assumption needs support. The terminal-growth rate must be below the discount rate and consistent with the economics. If continuation cannot be supported, the higher result cannot repair the model.

Record the finite-life and continuing-business cases separately, then test the assumptions relevant to the actual business. The calculation makes the difference visible; it does not choose the favourable case for you.

Use multiples as a cross-check#

If a comparable company's shares trade at twenty times earnings, that does not establish that your company deserves the same multiple. Growth, margins, financing, accounting and risk can differ.

Likewise, a company's historical average may reflect conditions that no longer apply. Our historical-valuation guide explains how to keep periods and definitions consistent.

Finish with an uncertainty note#

Record the source of each historical input, the reason for each forecast assumption and the sensitivity that changes the conclusion most. Include dilution and financing needs where relevant. If small, plausible changes reverse the result, say so.

The useful output is a model you can explain and revise. It cannot determine your personal risk capacity, portfolio allocation or whether you should trade.