From Narratives To Numbers

Now, once you have developed a story or have listened to a story which passes at least the plausibility test, it’s time for you to provide numbers to such stories.  

The intrinsic value is the value you would attach to an asset based upon its fundamentals: cash flows, expected growth, and risk. At its core, if you stay true to its principles, a DCF model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk.

This is how a typical valuation model through DCF looks like.

So the E(CF1), E(CF2), etc are the expected free cash flows that the company will be able to generate in the future years. These are estimations and hence requires deep knowledge about the industry and company. 

Free cash flow to a company is calculated as: 

Revenue x Operating Profit Margins x (1-Tax Rate) = Post Tax Operating Margin – Reinvestment = Free Cash Flow to the Firm

The calculation of free cash flow as per Damodaran’s model requires three major estimates:

The expected sales, expected operating margins and the expected reinvestment. 

As you can see here, once a story is established, the DCF model requires numbers to it. This means that no matter whether your story is fascinating and looks possible and plausible, valuation will still require numbers to be attached to those stories. Let's look at how to input numbers into a story.

Connecting stories to Valuation inputs:

Professor Damodaran has provided an example of how he connected his story/narrative on Uber (As discussed in the previous chapter) to numbers to be used in the DCF valuation.