"The value of the company is the present value of free cash flows, discounted at the weighted average cost of capital rate."
Some time ago when I was working in the business area of a Financial Institution, I submitted to the Risk Unit an application for a credit card for a client's working capital, which was rejected and, due to my persistence, approved, but for such a small amount., that its issuance was impossible, as it was less than the minimum amount of the product. In short, it was literally denied, but in a more subtle way.
The argument I received from the Risk Office at the time was that "it could not be awarded a larger amount, because that was what the company was worth."
And how much is the company worth? I asked.
"The amount of its capital stock", I received by reply.
Following the same logic, I asked: and why not heritage ?.
"Why can accumulated profits be withdrawn at any time?" He added.
Before such a crazy argument, I could not contain myself and I replied: The value of a company is not the capital stock, nor the net worth, it is the present value of the free cash flows, discounted at the weighted average cost of capital rate, in a valuation period.
"Well Ivan, that's your point of point," he concluded.
The above anecdote is brought up because many entrepreneurs and even people linked to Credit Institutions do not know how the value of a company is determined, which generates economic damages and loss of business opportunities, which could be avoided.
To determine the value of a company it is necessary to calculate the following variables:
1. Free Cash Flows or Free Cash Flow (FCF), 2. The Weighted Average Cost of Capital (WACC), and
3. The Valuation Period (evaluation horizon).
1. Free Cash Flows
They are the result of subtracting from EBITDA (Operating Income - Taxes + Depreciation and other charges that are not cash), investments in Fixed Assets (Changes in Fixed Assets + Depreciation) and Net Current Assets (Changes in Current Assets - Liabilities). Currents); and they represent the amount of cash available, year after year, to the creditors and owners of the company, after complying with the payment of all operating needs, investments in fixed assets and current business assets. These FCCs must be carried at Present Value, discounted with the WACC and their sum will determine the Value of the company.
2. The Weighted Average Cost of Capital
As for the WACC, it is the sum of the multiplication of the specific cost of each form of financing by its proportion in the capital structure of the company.
The forms of financing are usually debts with banks, stocks and retained earnings. The cost of financing the shares and retained earnings will be given by the Capital Asset Valuation Model (CAPM); while the cost of the debt with banks will be the Annual Effective Cost Rate (TCEA), from which the effect of the payment of taxes must be deducted.
Regarding the weighting, the proportion that each type of financing has in the financial structure of the company is usually used.
3. The Valuation Period
Finally, the evaluation horizon will depend on the type of business.
Finally, returning to the case of the working capital credit card evaluation, the credit evaluation should not have focused on the value of the company, but on its ability to pay, through the analysis of the liquidity of the business.
