The 12-Week MBA Chapter 9: Valuation Foundations - What Is a Company Actually Worth?
On April 19, 2022, Netflix told the world it lost 200,000 subscribers. The stock dropped by a third in one day. Fifty billion dollars of shareholder value just vanished. But how do you even put a price tag on a company in the first place?
This is post 11 in my 12-Week MBA retelling series.
Chapter 9 answers the question we have been building toward this entire time: what is a company actually worth? The authors warned us early in the book that shareholder value comes from “discounted future net cash flows.” Now they finally unpack what that means. And honestly, the math is simpler than you might think.
The Time Value of Money
Let us start with a thought experiment from the book. You give someone $100 today, and they promise to give you something back in a year. How much do you want back?
If you lend a book to a friend, you just want the book back. Maybe a little beat up, but the same book. With money and business, your expectations are different. You want more than $100 back. Not because you are greedy (well, maybe a little), but because of two real reasons.
Reason one: risk. That future payment is just a promise. Promises get broken. Your money is gone right now, and you have no guarantee it is coming back.
Reason two: opportunity cost. You could have put that $100 in a savings account earning interest. Even if the interest rate is only 2 percent, any risky investment has to beat the $102 you would have gotten risk-free. Otherwise, why bother?
This is what finance people call the time value of money. Cash in your hand right now is always worth more than the same amount promised for the future.
Lending Money to Connie
The book uses a great example to show how risk translates to real numbers. Imagine you lend $100 to someone named Connie. You are 95 percent sure she will pay you back. That sounds pretty good, right?
But think about it differently. If you made this exact same bet with 100 people who all seemed as trustworthy as Connie, 95 would pay you back and 5 would disappear forever. You invest $10,000 total and only get back $9,500. You lost money.
To break even across all 100 Connies, you need each one to promise to pay back about $105.27. That extra 5.27 percent is not a bonus. It is the minimum you need just to not lose money over time.
The authors round this up to 6 percent for simpler math, and they make an important point: if Connie pays you back the full amount, you did not actually earn 6 percent. You just got lucky and picked the right Connie. If you keep making investments like this, the losses from the bad ones will eat up the gains from the good ones. On average, you are just preserving your capital.
Discounting Future Cash Flows
Now here is where it gets interesting. What if Connie cannot pay everything back at once? She proposes to pay $53 per year for two years. That is $106 total, which looks like it covers your 6 percent return. But does it?
You have to discount each future payment back to what it is worth today. The first year’s $53 is worth $50.00 in today’s money (divided by 1.06). The second year’s $53 is worth only $47.17 because you divide by 1.06 twice. More time means more risk, so the same dollar amount is worth less.
Add those up: $50.00 + $47.17 = $97.17. That is less than your $100 investment. Connie’s payment plan does not actually compensate you for the risk. You would be losing money.
This approach is called discounted cash flow (DCF) analysis. The rule is simple to remember even if you never do the math yourself:
At the same level of risk, cash flows that come later are worth less than cash flows that come sooner. And cash flows you are less confident about are worth less than ones you trust.
Putting a Price on a Company
Now apply this same thinking to an entire business. An owner looks at a company as a series of promises of future cash flows. To figure out what the company is worth, you:
- Project the future cash flows
- Discount each one based on how far in the future it is and how risky it is
- Add them all up
The result is called the intrinsic value of the company. At that price, the owner would be indifferent between keeping the business and selling it.
The book walks through this with the food truck example. You project free cash flows of $1,000 in Year 1, $5,000 in Year 2, and $10,000 in Year 3. But to discount them, you need a specific number. What percentage do you use?
The Cost of Capital
That discount rate is called the cost of capital. It represents the minimum return investors demand for putting their money at risk.
The authors give three levels of depth on how to find this number.
Level one: ask the CFO. Someone in finance already figured it out. The authors admit this sounds like a copout, but they say you will be grateful for it once you see how complex the alternatives are.
Level two: understand what goes into it. The cost of capital reflects questions like: How predictable are the company’s sales? How sensitive are they to economic conditions? What is the company’s track record for hitting targets? How much debt does it have? How easy would it be to sell assets if things go wrong? How diversified is the customer base? All of these feed into one number.
Level three: look at what similar companies are paying. Find publicly traded companies in the same industry and size range. See what returns their investors have earned historically. Use that as your starting point and adjust up or down based on your company’s specific situation. The authors say this is how the professionals actually do it.
Cost of capital typically ranges from the mid-single digits (4 to 5 percent) up to 20 percent or more. The book mentions a multinational that had a 7.6 percent cost of capital for its Canadian operations and 23 percent for Nigeria. Same company, very different risk profiles.
What About Year 4 and Beyond?
You can discount three years of cash flows easily enough. But what about Year 4? Year 10? Year 50?
Here is the fascinating part. Unlike humans, companies do not have to die. Nokia started as a wood pulp mill in Finland in 1865. Today it makes telecommunications infrastructure. The founders would not recognize the company, but it is still generating cash flows over 150 years later.
So in theory, you need to add up an infinite number of future cash flows. The good news is that even an infinite series of ever-shrinking numbers adds up to a finite amount. If the food truck reaches a steady state of $10,000 per year in free cash flow at a 10 percent cost of capital, the value of all those future cash flows from Year 3 onward is:
$10,000 / 0.10 = $100,000
That number is called the continuing value. It captures everything from Year 3 to infinity in one figure. You then discount that continuing value back to the present just like any other future cash flow.
The Final Number
Put it all together for the food truck at a 10 percent cost of capital:
- Year 1: $1,000 cash flow, present value $909
- Year 2: $5,000 cash flow, present value $4,132
- Year 3: $10,000 cash flow, present value $7,513
- Continuing value: $100,000, present value $68,301
Total intrinsic value: $80,855.
One single number that captures the profitability, growth, and riskiness of the entire business. That is the answer to “What is this company worth?”
You Do Not Need to Do This Math
The authors are very clear about this. If your career takes you toward company valuation or mergers and acquisitions, you will learn these tools in depth. But for most managers, the mechanical details do not matter.
What matters is understanding that everything you do at work connects to these inputs. Your decisions affect profitability and growth, which determine future cash flows. The quality of information you share and how reliably you deliver results affects investor confidence, which determines the discount rate. It all rolls up into one number.
Your salary sits on a line item in the P&L. Your forecasts flow into the projections. Your reliability affects how much investors trust the company’s promises. You are part of this equation whether you know it or not.
Key Takeaway
A company’s intrinsic value is the sum of its expected future cash flows, discounted by the cost of capital. That sounds technical, but the idea is intuitive: a company is worth whatever cash it can generate in the future, adjusted for how confident you are it will actually happen.
You do not need to memorize formulas. You need to understand that your work directly feeds into the three things that drive company value: profitability, growth, and risk. Every decision you make, every report you file, every target you hit or miss is part of the story investors are betting on.
Book: The 12-Week MBA by Nathan Kracklauer & Bjorn Billhardt | ISBN: 978-0-306-83236-9
Previous: Chapter 8 - Cost Structures
Next up: Chapter 10 - Creating Value - How every manager connects to value.
Part of the 12-Week MBA retelling series