Corporate Finance Fundamentals: Valuation Basics—What a Company Is Worth and Why

Valuation as a disciplined link between cash flows, growth, risk, and price

Valuation is the process of translating a business story (how the company makes money and how it might grow) into a number (what it is worth today). The discipline comes from forcing every claim—“we’ll grow fast,” “margins will improve,” “this is a safe business”—to show up in a model through three levers:

• Expected cash flows: how much cash the business can generate for investors over time.
• Growth: how those cash flows change (often grow) over time.
• Risk: how uncertain those cash flows are, reflected in the return investors require.

Price is what the market pays; value is what your assumptions imply. When price and value differ, the gap is where decisions happen (invest, acquire, divest, hold, negotiate).

Three beginner-friendly approaches (and what each is really doing)

1) Discounted Cash Flow (DCF): value from fundamentals

A DCF asks: “If I owned this business, what cash would it generate for me, and what is that cash worth today?” You forecast cash flows, then discount them at a rate that reflects risk. Most of the work is not math; it is choosing assumptions that are consistent with how the business operates.

Common DCF variants differ mainly in which cash flows you discount:

• Free cash flow to the firm (FCFF) discounted at the company’s overall required return gives enterprise value (value of operations for all capital providers).
• Free cash flow to equity (FCFE) discounted at the equity required return gives equity value.

In this chapter we use a simple FCFF-style DCF and then convert to equity value.

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2) Comparable company multiples: value from market pricing

Multiples value a company by reference to how similar companies are priced. The logic is: “If peers trade at X times earnings (or EBITDA), what would our company be worth at that same X?”

• P/E compares equity value to earnings available to equity holders.
• EV/EBITDA compares enterprise value to an operating profit proxy before financing and non-cash charges.

Multiples are fast and market-anchored, but they inherit the market’s mood and require careful “apples-to-apples” adjustments (growth, margins, risk, accounting differences).

3) Assumptions drive outcomes: valuation is a sensitivity exercise

Two analysts can value the same company differently because they made different assumptions about growth, margins, reinvestment needs, or risk. A good valuation makes those assumptions explicit, tests them, and shows which ones matter most.

Guided valuation example: a simple business

Assume a small subscription software business (“SimpleSoft”) with stable customers and moderate growth. We will value it using:

• A basic DCF (fundamental value)
• A multiples cross-check (market-based reasonableness)

Given information (simplified)

These inputs are intentionally clean so you can focus on mechanics and intuition.

Part A: Basic DCF step-by-step

Step 1: Forecast revenue for 5 years

Revenue grows at 8% annually:

Year 1: 10.00m  (given)  Year 4: 12.60m  (10.00 * 1.08^3)Year 2: 10.80m           Year 5: 13.61mYear 3: 11.66m

Step 2: Forecast operating profit (EBIT) and after-tax operating profit (NOPAT)

EBIT = 15% of revenue. NOPAT = EBIT × (1 − tax rate).

Interpretation: NOPAT is the after-tax profit from operations, before considering financing (interest). It is a core building block for FCFF.

Step 3: Convert NOPAT to free cash flow to the firm (FCFF)

A simple FCFF bridge is:

FCFF = NOPAT + Depreciation − Capital Expenditures − Increase in Net Working Capital

Using the percentage assumptions:

• Depreciation = 2% of revenue
• Capex = 3% of revenue
• Working capital investment = 1% of revenue

So the net reinvestment drag each year is: +2% −3% −1% = −2% of revenue. Therefore:

FCFF = NOPAT − 0.02 × Revenue

Interpretation: Even profitable companies may have lower free cash flow if they must reinvest heavily. Here, reinvestment is moderate, so FCFF tracks NOPAT fairly closely.

Step 4: Discount the forecast cash flows to present value

Discount factor for year t is 1/(1+r)^t with r = 10%.

Sum of PVs (Years 1–5) ≈ $4.06m.

Step 5: Estimate terminal value (value beyond Year 5)

Because businesses are assumed to continue, a DCF typically adds a terminal value. A common beginner method is the perpetual growth model:

Terminal Value at Year 5 = FCFF_6 / (r − g)

Compute FCFF in Year 6 by growing Year 5 FCFF at long-run growth g = 3%:

FCFF_6 = 1.259 × 1.03 ≈ 1.297mTerminal Value (Year 5) = 1.297 / (0.10 − 0.03) ≈ 18.53m

Discount terminal value back to today:

PV(Terminal Value) = 18.53 × 0.621 ≈ 11.50m

Step 6: Compute enterprise value and equity value

Enterprise value (EV) is the value of operations:

EV = PV(Years 1–5 FCFF) + PV(Terminal Value)≈ 4.06 + 11.50 = 15.56m

Convert EV to equity value by subtracting net debt:

Equity Value = EV − Net Debt≈ 15.56 − 5.00 = 10.56m

DCF result: EV ≈ $15.6m, Equity value ≈ $10.6m.

Part B: Multiples cross-check step-by-step

Now we ask: “If the market values similar businesses at certain multiples, what valuation would that imply for SimpleSoft?” We will use EV/EBITDA and P/E as two common lenses.

Step 1: Compute the company’s Year 1 EBITDA and earnings (simplified)

We have EBIT and depreciation. EBITDA ≈ EBIT + Depreciation.

Note: For a true P/E you would use net income after interest. Here we use a simplified proxy to focus on the mechanics; in practice you would incorporate financing costs and any non-operating items.

Step 2: Apply peer multiples to estimate value

Assume the peer group trades around:

• EV/EBITDA = 9×
• P/E = 12×

EV/EBITDA method:

Implied EV = 9 × EBITDA = 9 × 1.70 = 15.30mImplied Equity Value = EV − Net Debt = 15.30 − 5.00 = 10.30m

P/E method (using simplified net income proxy):

Implied Equity Value = 12 × Net Income = 12 × 1.125 = 13.50m

So the multiples cross-check gives a range:

• EV/EBITDA implies equity ≈ $10.3m (close to the DCF)
• P/E implies equity ≈ $13.5m (higher than the DCF)

Reconciling results: why DCF and multiples can differ

1) Different methods “see” different things

• DCF explicitly models reinvestment needs and long-run economics. If growth requires heavy reinvestment, DCF will penalize value through lower free cash flow.
• EV/EBITDA focuses on operating performance before depreciation and financing. It can overvalue businesses that need large capital expenditures (because EBITDA ignores capex).
• P/E is sensitive to capital structure and accounting. Two companies with identical operations can have different P/E ratios due to leverage, interest expense, tax effects, or one-time items.

2) Timing differences: “this year” vs “the future”

Multiples often use current or next-year metrics. DCF is dominated by the long-term (especially the terminal value). If the market expects faster growth or higher margins than your DCF assumes, multiples may imply a higher value.

3) Embedded assumptions inside multiples

A peer multiple is not assumption-free; it hides assumptions about growth, risk, and reinvestment inside the market price of the comparable companies. When you apply a multiple, you are implicitly saying: “Our company deserves the same bundle of assumptions as the peer group.”

4) Capital structure and “what is being valued”

EV/EBITDA yields enterprise value; P/E yields equity value. Mixing them without consistent adjustments can create apparent disagreements. A practical discipline is:

• Use EV-based multiples (EV/EBITDA, EV/Sales) to compare operating businesses regardless of leverage.
• Use equity-based multiples (P/E, P/B) when leverage and accounting are comparable and stable.

What the differences imply for decision-making

Use DCF to understand the value drivers you can control

DCF is useful when you need to make operational or strategic decisions because it forces clarity on:

• How growth translates into cash (and what reinvestment it requires)
• Which margins are realistic
• How sensitive value is to risk and long-run growth

For example, if a proposed initiative increases revenue growth from 8% to 10% but also increases working capital and capex needs, DCF helps you see whether value actually increases after reinvestment.

Use multiples to sanity-check and to negotiate

Multiples help answer: “Is my DCF output in the neighborhood of market pricing?” If your DCF implies EV/EBITDA of 6× while peers trade at 9×, you need to explain why:

• Are your cash flow assumptions too conservative?
• Is the company riskier or lower quality than peers?
• Are peers temporarily overpriced (or underpriced)?

Turn valuation into a range, not a single point

Because assumptions drive outcomes, decision-makers often work with ranges. A simple way is to vary the two biggest DCF levers:

• Discount rate (risk): e.g., 9% to 11%
• Long-run growth: e.g., 2% to 4%

Even small changes can move value meaningfully because terminal value is often a large portion of EV.

Quick assumption checklist (to keep valuations internally consistent)

• Growth vs reinvestment: If you assume high growth, do you also assume the investments needed to support it (capex, working capital, hiring)?
• Margins vs competition: If margins expand, what operational change makes that plausible (pricing power, scale, cost reductions)?
• Terminal growth: Is long-run growth reasonable relative to the broader economy and industry maturity?
• Multiple selection: Are the comparables similar in growth, profitability, and risk? Are you using forward or trailing metrics consistently?
• Bridge between EV and equity: Did you adjust for net debt (and other non-operating assets/liabilities if material)?