The basic essence of valuation is to identify/assess the profits made by an asset, growth of those profits in future and the risk behind achieving those profits. The motivation behind the process is to understand the value of the underlying asset we intend to buy. The process can be intrinsic (evaluate the asset as a stand alone) or relative (in comparison with a comparable asset).
We think about how money grows over time. INR 100 today in the bank account yielding 10% interest, would be of value – INR 110 in a year. If we flip things around; and say you receive INR 110 in a year’s time, what would be its value today? The discounted value of 100 today is the net present value of a cash flow of INR110 expected in a year’s time.
The first step is to identify the free cash flows to the firm for each year, over the valuation period considered. The cash flows can be individually calculated for each year, if we have the necessary information or assumed to be growing at a constant growth rate.
The investors would not place a bet on the riskier cash flows if the profit expectations from taking that risk doesn’t not commensurate with each other. So the cash flows need to be adjusted accordingly to incorporate the corresponding risk – by discounting it.
Discount rate converts the future cash flows to their present value. It has to discussed consistently with the free cash flows – if it is free cash flow to the firm, then it is cost of capital; if it is cash flows to equity, then it is cost of equity. And they can change over time depending on the business model. If the cash flows are calculated in INR, then the risk free rate should be of same denomination.
Intrinsic valuation identifies the net present value of the future cash flows by accounting for growth rate of such cash flows and discounting for the corresponding risk.
