{
  "id": 35785,
  "date": "2021-06-04T11:30:00",
  "date_gmt": "2021-06-04T11:30:00",
  "guid": { "rendered": "https:\/\/finance-able.com\/?p=35785" },
  "modified": "2021-11-09T00:56:42",
  "modified_gmt": "2021-11-09T05:56:42",
  "slug": "how-to-value-a-business-made-simple",
  "status": "publish",
  "type": "post",
  "link": "https:\/\/finance-able.com\/how-to-value-a-business-made-simple\/",
  "title": {
    "rendered": "How to Value a Business…Made Simple – Learn Finance ASAP #2"
  },
  "content": {
    "rendered": "\n<p>Learn <strong>How to Value a Business <\/strong>with a simplified, <strong>Plain English explanation<\/strong> that uses the <strong>House you live in as an Analog<\/strong>. We&#8217;ll cover everything from the basics to more advanced business valuation methods like <strong>Discounted Cash Flow Analysis<\/strong>. <\/p>\n\n\n\n<p class=\"yoast-reading-time__wrapper\"><span class=\"yoast-reading-time__icon\"><svg aria-hidden=\"true\" focusable=\"false\" data-icon=\"clock\" width=\"20\" height=\"20\" fill=\"none\" stroke=\"currentColor\" style=\"display:inline-block;vertical-align:-0.1em\" role=\"img\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" viewbox=\"0 0 24 24\"><path stroke-linecap=\"round\" stroke-linejoin=\"round\" stroke-width=\"2\" d=\"M12 8v4l3 3m6-3a9 9 0 11-18 0 9 9 0 0118 0z\"><\/path><\/svg><\/span><span class=\"yoast-reading-time__spacer\" style=\"display:inline-block;width:1em\"><\/span><span class=\"yoast-reading-time__descriptive-text\">Estimated reading time:  <\/span><span class=\"yoast-reading-time__reading-time\">12<\/span><span class=\"yoast-reading-time__time-unit\"> minutes<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-tl-dr\"><strong>TL;DR<\/strong><\/h2>\n\n\n\n<ul class=\"wp-block-list\"><li>Learning <strong>How to Value a Business<\/strong> is central to nearly any role in the Finance world.<\/li><li>The two most common <strong>Business Valuation Methods<\/strong> are <strong>Intrinsic (Cash Flow-Based) Valuation <\/strong>and <strong>Multiple-Based Valuation<\/strong>. <\/li><li>The basis for valuing the vast majority of <strong>Businesses <\/strong>is their future <strong>Cash Flows<\/strong>.<\/li><li>To value future <strong>Cash Flows<\/strong>,<strong> <\/strong>we perform a <strong>Discounted Cash Flow <\/strong>(<strong>DCF<\/strong>) analysis which utilizes <strong>Discounting <\/strong>to pull future <strong>Cash Flows<\/strong> back to today. <\/li><li>The total value of all future <strong>Cash Flows <\/strong>when <strong>Discounted <\/strong>back to today gives us the <strong>Purchase Price <\/strong>of the <strong>Business <\/strong>(or <strong>Enterprise Value<\/strong>).<\/li><\/ul>\n\n\n\n<div style=\"height:40px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<div style=\"height:40px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<div class=\"wp-block-columns containerwidth is-layout-flex wp-container-core-columns-is-layout-9d6595d7 wp-block-columns-is-layout-flex\">\n<div class=\"wp-block-column is-layout-flow wp-block-column-is-layout-flow\" style=\"flex-basis:100%\">\n<div class=\"wp-block-kadence-rowlayout alignnone\"><div id=\"kt-layout-id_fb133e-87\" class=\"kt-row-layout-inner kt-layout-id_fb133e-87\"><div class=\"kt-row-column-wrap kt-has-1-columns kt-gutter-default kt-v-gutter-default kt-row-valign-top kt-row-layout-equal kt-tab-layout-inherit kt-m-colapse-left-to-right kt-mobile-layout-row\">\n<div class=\"wp-block-kadence-column inner-column-1 kadence-column_fc52a9-b0\"><div class=\"kt-inside-inner-col\" style=\"background:#f4f4f4\">\n<h2 class=\"wp-block-heading\" id=\"h-want-to-learn-more-about-finance\" style=\"font-size:35px\"><strong>Want To Learn More About Finance?<\/strong><\/h2>\n\n\n\n<p style=\"font-size:18px\"><strong>Check out all of our (free) deep-dive articles in our<\/strong> <a href=\"https:\/\/finance-able.com\/analyst-starter-kit\/\" target=\"_blank\" rel=\"noreferrer noopener\"><strong><span class=\"has-inline-color has-vivid-cyan-blue-color\">Analyst Starter Kit<\/span><\/strong><\/a>:<\/p>\n\n\n<div class=\" wp-block-kadence-portfoliogrid kb-blocks-portfolio-loop-block alignnone kb-portfolio-loop_3e5830-3e kb-portfolio-grid-layout-carousel kt-blocks-carousel \"><div class=\" kb-portfolio-grid-layout-carousel-wrap kt-post-grid-layout-carousel-wrap kt-carousel-arrowstyle-whiteondark kt-carousel-dotstyle-dark splide kb-blocks-portfolio-img-hover-zoomout kb-blocks-portfolio-content-hover-zoomin\" data-columns-xxl=\"3\" data-columns-xl=\"3\" data-columns-md=\"3\" data-columns-sm=\"2\" data-columns-xs=\"1\" data-columns-ss=\"1\" data-slider-center-mode=\"false\" data-slider-type=\"carousel\" data-slider-anim-speed=\"400\" data-slider-scroll=\"1\" data-slider-dots=\"true\" data-slider-arrows=\"true\" data-slider-hover-pause=\"false\" data-slider-auto=\"true\" data-slider-center-mode=\"false\" data-slider-speed=\"7000\" data-show-pause-button=\"false\" data-slider-gap=\"30\" data-slider-gap-tablet=\"30\" data-slider-gap-mobile=\"30\" data-slider-gap-unit=\"px\" data-item-selector=\".kb-portfolio-masonry-item\"><div class=\"kadence-splide-slider-init splide__track\"><ul><li class=\"kb-portfolio-slider-item kb-slide-item\"><div class=\"kb-blocks-portfolio-grid-item\"><div class=\"kb-blocks-portfolio-grid-item-inner-wrap kb-feat-image-align-none\"><div class=\"kadence-portfolio-image\"><div class=\"kadence-portfolio-image-intrisic kt-image-ratio-nocrop\" style=\"padding-bottom:56.25%\"><div class=\"kadence-portfolio-image-inner-intrisic\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"576\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2023\/03\/unlevered-beta-formula-lightbulb-1024x576.png\" class=\"attachment-large size-large wp-post-image\" alt=\"An image of a lightbulb with the text Unlevered Beta Formula\" srcset=\"https:\/\/finance-able.com\/wp-content\/uploads\/2023\/03\/unlevered-beta-formula-lightbulb-1024x576.png 1024w, https:\/\/finance-able.com\/wp-content\/uploads\/2023\/03\/unlevered-beta-formula-lightbulb-300x169.png 300w, https:\/\/finance-able.com\/wp-content\/uploads\/2023\/03\/unlevered-beta-formula-lightbulb-768x432.png 768w, https:\/\/finance-able.com\/wp-content\/uploads\/2023\/03\/unlevered-beta-formula-lightbulb.png 1280w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><\/div><\/div><\/div><div class=\"kb-portfolio-grid-item-inner\"><a href=\"https:\/\/finance-able.com\/unlevered-beta-formula\/\" aria-label=\"Unlevered Beta Formula &#8211; Ultimate Guide\" class=\"portfolio-hover-item-link\"><\/a><div class=\"kb-portfolio-overlay-color\"><\/div><div class=\"kb-portfolio-overlay-border\"><\/div><div class=\"kb-portfolio-content-item-inner\"><h3 class=\"entry-title kb-portfolio-loop-title\">Unlevered Beta Formula &#8211; Ultimate Guide<\/h3><\/div><\/div><\/div><\/div><\/li><li class=\"kb-portfolio-slider-item kb-slide-item\"><div class=\"kb-blocks-portfolio-grid-item\"><div class=\"kb-blocks-portfolio-grid-item-inner-wrap kb-feat-image-align-none\"><div class=\"kadence-portfolio-image\"><div class=\"kadence-portfolio-image-intrisic kt-image-ratio-nocrop\" style=\"padding-bottom:56.25%\"><div class=\"kadence-portfolio-image-inner-intrisic\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"576\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2023\/01\/lightbulb-purchase-price-allocation-1024x576.png\" class=\"attachment-large size-large wp-post-image\" alt=\"A lightbulb and the words Purchase Price Allocation\" srcset=\"https:\/\/finance-able.com\/wp-content\/uploads\/2023\/01\/lightbulb-purchase-price-allocation-1024x576.png 1024w, https:\/\/finance-able.com\/wp-content\/uploads\/2023\/01\/lightbulb-purchase-price-allocation-300x169.png 300w, https:\/\/finance-able.com\/wp-content\/uploads\/2023\/01\/lightbulb-purchase-price-allocation-768x432.png 768w, https:\/\/finance-able.com\/wp-content\/uploads\/2023\/01\/lightbulb-purchase-price-allocation.png 1280w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><\/div><\/div><\/div><div class=\"kb-portfolio-grid-item-inner\"><a href=\"https:\/\/finance-able.com\/purchase-price-allocation\/\" aria-label=\"Purchase Price Allocation in 4 Steps &#8211; The Ultimate Guide\" class=\"portfolio-hover-item-link\"><\/a><div class=\"kb-portfolio-overlay-color\"><\/div><div class=\"kb-portfolio-overlay-border\"><\/div><div class=\"kb-portfolio-content-item-inner\"><h3 class=\"entry-title kb-portfolio-loop-title\">Purchase Price Allocation in 4 Steps &#8211; The Ultimate Guide<\/h3><\/div><\/div><\/div><\/div><\/li><li class=\"kb-portfolio-slider-item kb-slide-item\"><div class=\"kb-blocks-portfolio-grid-item\"><div class=\"kb-blocks-portfolio-grid-item-inner-wrap kb-feat-image-align-none\"><div class=\"kadence-portfolio-image\"><div class=\"kadence-portfolio-image-intrisic kt-image-ratio-nocrop\" style=\"padding-bottom:45.138888888889%\"><div class=\"kadence-portfolio-image-inner-intrisic\"><img loading=\"lazy\" decoding=\"async\" width=\"720\" height=\"325\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/06\/0-Walk-Me-Through-a-DCF-Definitive-Guide-Cover-1.png\" class=\"attachment-large size-large wp-post-image\" alt=\": A stick figure answering an interview question with the title text &#039;Walk Me Through an LBO&#039; below\" srcset=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/06\/0-Walk-Me-Through-a-DCF-Definitive-Guide-Cover-1.png 720w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/06\/0-Walk-Me-Through-a-DCF-Definitive-Guide-Cover-1-300x135.png 300w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/06\/0-Walk-Me-Through-a-DCF-Definitive-Guide-Cover-1-400x181.png 400w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/06\/0-Walk-Me-Through-a-DCF-Definitive-Guide-Cover-1-624x282.png 624w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/06\/0-Walk-Me-Through-a-DCF-Definitive-Guide-Cover-1-50x23.png 50w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/06\/0-Walk-Me-Through-a-DCF-Definitive-Guide-Cover-1-100x45.png 100w\" sizes=\"auto, (max-width: 720px) 100vw, 720px\" \/><\/div><\/div><\/div><div class=\"kb-portfolio-grid-item-inner\"><a href=\"https:\/\/finance-able.com\/walk-me-through-a-dcf\/\" aria-label=\"Walk Me Through a DCF in 5 Steps &#8211; The Ultimate Guide\" class=\"portfolio-hover-item-link\"><\/a><div class=\"kb-portfolio-overlay-color\"><\/div><div class=\"kb-portfolio-overlay-border\"><\/div><div class=\"kb-portfolio-content-item-inner\"><h3 class=\"entry-title kb-portfolio-loop-title\">Walk Me Through a DCF in 5 Steps &#8211; The Ultimate Guide<\/h3><\/div><\/div><\/div><\/div><\/li><\/ul><\/div><div class=\"clearfix\" style=\"clear:both\"><\/div><\/div><\/div><\/div><\/div>\n<\/div><\/div><\/div>\n\n\n\n<div style=\"height:100px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n<\/div>\n<\/div>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-introduction-how-to-value-a-business\"><strong>Introduction &#8211; How to Value a Business<\/strong><\/h2>\n\n\n\n<p>Welcome to Article #2 in our <a href=\"https:\/\/finance-able.com\/the-world-of-finance\/\" target=\"_blank\" rel=\"noreferrer noopener\"><span class=\"has-inline-color has-vivid-cyan-blue-color\">Learn Finance ASAP<\/span><\/a> series! <\/p>\n\n\n\n<p>In this article, we&#8217;ll dig into the concept of <strong>Intrinsic (i.e. Cash Flow-Based) Valuation <\/strong>and how it applies to both <strong>Houses<\/strong> and <strong>Businesses<\/strong>. <\/p>\n\n\n\n<p>If you missed our <a href=\"https:\/\/finance-able.com\/learn-finance-foundational-framework\/\"><span class=\"has-inline-color has-vivid-cyan-blue-color\">first article<\/span><\/a> in the series, we recommend that you read it before diving into this one.<\/p>\n\n\n\n<p>In that article, we explained that both <strong>Houses <\/strong>and <strong>Businesses <\/strong>are <strong>Cash Flow Generating Assets <\/strong>(or <strong>CFGA<\/strong>s for short). <\/p>\n\n\n\n<p>In this article, we&#8217;ll add to our <strong>Mental Model<\/strong> by showing that any <strong>CFGA <\/strong>(including <strong>Houses<\/strong> and <strong>Businesses<\/strong>) is valued based on the future <strong>Cash Flows<\/strong> that they generate. <\/p>\n\n\n\n<p>But we need to quickly tackle one thing first! <\/p>\n\n\n\n<p>In my experience, training on <strong>Business Valuation Methods<\/strong> often fails to include an overview of <strong><em>when<\/em><\/strong> and <strong><em>why<\/em><\/strong> we are valuing things in the first place. <\/p>\n\n\n\n<p>That&#8217;s where we&#8217;ll start to give you a <strong>big-picture view<\/strong> of a <strong>few real-life scenarios<\/strong> where Finance Professionals utilize the <strong>Business Valuation Methods<\/strong> we&#8217;re about to explore.  <\/p>\n\n\n\n<p>Once we&#8217;ve nailed down the <em><strong>when <\/strong><\/em>and <strong><em>why<\/em><\/strong>, we can get into the nuts and bolts of this and further add to the <strong>Mental Model<\/strong> we started building in <a href=\"https:\/\/finance-able.com\/learn-finance-foundational-framework\/\"><span class=\"has-inline-color has-vivid-cyan-blue-color\">Article #1<\/span><\/a>.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-why-do-we-need-to-value-a-business-who-really-cares\"><strong>Why Do We Need To Value a Business? Who Really Cares?<\/strong><\/h2>\n\n\n\n<p>In <a href=\"https:\/\/finance-able.com\/learn-finance-foundational-framework\/\"><span class=\"has-inline-color has-vivid-cyan-blue-color\">Article #1<\/span><\/a>, we said that a core question in Finance is, <strong>&#8220;What is the business worth?&#8221;<\/strong>. <\/p>\n\n\n\n<p>Let&#8217;s take a look at a few examples of where that question might arise: <\/p>\n\n\n\n<ul class=\"wp-block-list\"><li><span style=\"text-decoration: underline;\"><a href=\"https:\/\/finance-able.com\/world-of-finance-4-how-do-investment-banks-operate\/\" target=\"_blank\" rel=\"noreferrer noopener\"><span class=\"has-inline-color has-vivid-cyan-blue-color\"><strong>Investment Banking<\/strong><\/span><\/a><\/span><strong>:<\/strong> A client hires you to sell their business and you need to figure out how much they should sell it for.<\/li><li><strong><span style=\"text-decoration: underline;\">Private Equity<\/span>:<\/strong> Your team decides to buy a company and you need to work out its value to know how much you should pay for it.<\/li><li><strong><span style=\"text-decoration: underline;\">Investment Management<\/span>: <\/strong>A portfolio manager asks you how much the value of a stock could increase over the next year and you need to determine its projected valuation.<\/li><li><strong><span style=\"text-decoration: underline;\">Corporate M&amp;A<\/span>:<\/strong> You want to make an acquisition but you\u2019re not sure if the price proposed by the seller makes sense.&nbsp;<\/li><\/ul>\n\n\n\n<p>To answer any of these questions, we need a strong understanding of <strong>Business Valuation<\/strong>. <\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-how-to-value-a-business-two-common-methods\"><strong>How to Value a Business: Two Common Methods<\/strong><\/h2>\n\n\n\n<p>Broadly speaking, there are two major Business Valuation Methods: <strong>Intrinsic Valuation <\/strong>and<strong> Multiple-based Valuation<\/strong>:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li><strong><span style=\"text-decoration: underline;\">Intrinsic Valuation<\/span>: <\/strong>we value the <strong>Business<\/strong> (or <strong>House<\/strong>) based on the <a href=\"https:\/\/www.investopedia.com\/terms\/c\/cashflow.asp#:~:text=Cash%20flow%20is%20the%20net,free%20cash%20flow%20(FCF).\" target=\"_blank\" rel=\"noreferrer noopener\"><span class=\"has-inline-color has-vivid-cyan-blue-color\"><strong>Cash Flows<\/strong><\/span><\/a> that it will generate in the future.<\/li><li><strong><span style=\"text-decoration: underline;\">Multiple-Based Valuation<\/span>:<\/strong> we look at the <strong>Purchase Price <\/strong>of a <strong>Business<\/strong> relative to its <strong>Cash Flow<\/strong>. <\/li><\/ul>\n\n\n\n<p>As we&#8217;ll see in <strong>Article #3<\/strong> in this series, Multiple-Based valuation is just a <em>&#8216;shorthand&#8217;<\/em> method. In fact, it&#8217;s actually an <strong>Intrinsic Valuation in disguise<\/strong>. More on that later. <\/p>\n\n\n\n<p>For now, we\u2019re going to focus on the <strong>Intrinsic Valuation<\/strong> methods. <\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-how-to-value-a-business-house-example\"><strong>How to Value a Business: House Example<\/strong><\/h2>\n\n\n\n<p>Let\u2019s imagine (as we did in <a href=\"https:\/\/finance-able.com\/learn-finance-foundational-framework\/\"><span class=\"has-inline-color has-vivid-cyan-blue-color\">Article #1<\/span><\/a>) that we rent out our <strong>House<\/strong> and, as such, that it becomes a &#8216;<strong>Business<\/strong>&#8216;.<\/p>\n\n\n\n<p>In this situation, though, we\u2019ll add a twist and change the example to <span style=\"text-decoration: underline;\"><strong>two<\/strong><\/span> <strong>Houses<\/strong> that we own and rent out:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li><strong><span style=\"text-decoration: underline;\">House #1<\/span>:<\/strong> Located in a remote, rural area.<\/li><li><strong><span style=\"text-decoration: underline;\">House #2<\/span>: <\/strong>Located in a big city (e.g. San Francisco, New York, etc.).<\/li><\/ul>\n\n\n\n<p>Let\u2019s also imagine that both <strong>Houses <\/strong>are:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>The same exact size.<\/li><li>Sit on land that is the exact same size.<\/li><li>Are built with the exact same materials.<\/li><\/ul>\n\n\n\n<p><\/p>\n\n\n\n<p style=\"font-size:27px\"><strong>Based on the information above, if you were to sell each house tomorrow, which would be worth more?<\/strong><\/p>\n\n\n\n<p><br><\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"720\" height=\"405\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_2.png\" alt=\"An illustration of a house in the city and a house in the country on a balance beam\" class=\"wp-image-36262\" srcset=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_2.png 720w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_2-300x169.png 300w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_2-400x225.png 400w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_2-624x351.png 624w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_2-50x28.png 50w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_2-100x56.png 100w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_2-600x338.png 600w\" sizes=\"auto, (max-width: 720px) 100vw, 720px\" \/><\/figure><\/div>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-the-answer\"><strong>The Answer<\/strong><\/h2>\n\n\n\n<p><strong>Was your answer the house in the City? <\/strong><\/p>\n\n\n\n<p>It seems like intuitive that it would be the case, right? <\/p>\n\n\n\n<p>Well, <strong>you are correct<\/strong>. <strong>But why is that the case?<\/strong><\/p>\n\n\n\n<p>Weren\u2019t the houses both the same size? <\/p>\n\n\n\n<p>Didn&#8217;t they sit on the same sized plot of land? <\/p>\n\n\n\n<p>Weren&#8217;t they build with the exact same materials? <\/p>\n\n\n\n<p><\/p>\n\n\n\n<p>The reason one is worth more than the other is <strong>Cash Flow<\/strong>!<\/p>\n\n\n\n<p>Despite their many similarities, the fact that you can charge <strong><u>FAR<\/u><\/strong> more to rent out a house in a Major City (in most cases) than in a Rural area makes the city house worth more.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1920\" height=\"1080\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/1-City-vs-Country-Rent.gif\" alt=\"A GIF showing that rent in the city is much greater as rent in the country\" class=\"wp-image-39508\"\/><\/figure><\/div>\n\n\n\n<p style=\"font-size:19px\"><strong>In short, the amount of rental income you could generate (i.e. Cash Flow) from a house is what drives what buyers will pay.<\/strong><\/p>\n\n\n\n<p>Even if, as buyers, we don\u2019t usually look at houses as potential businesses or think about a house this way when we purchase a <strong>House<\/strong>.&nbsp;<\/p>\n\n\n\n<p>Note that in this instance, we&#8217;re assuming the cost of building both physical houses (or <strong>Asset Value<\/strong>) is the same. This is a bit of a simplifying assumption, but it helps us to build out our <strong>Mental Model<\/strong> for now&#8230;so let&#8217;s stick with it.  <\/p>\n\n\n\n<p>In short, <strong>Asset Value<\/strong> is not relevant to each House&#8217;s worth, since the <strong>Cash Flow value is greater<\/strong>.<\/p>\n\n\n\n<p style=\"font-size:19px\"><strong>The punchline is that a House is a Cash-Flow Generating Asset and the value for CFGA&#8217;s is a function of their future Cash Flow generation potential. <\/strong><\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1280\" height=\"720\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/2-Asset-Value-vs-Cash-Flow-Value-House.gif\" alt=\"A GIF showing Asset Value and Cash Flow Value for a house\" class=\"wp-image-39496\"\/><\/figure><\/div>\n\n\n\n<p><\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-how-to-value-a-traditional-business\"><strong>How to Value a &#8220;Traditional&#8221; Business<\/strong><\/h2>\n\n\n\n<p>If we switch our example to a traditional <strong>Business<\/strong>, we find that the same applies. <\/p>\n\n\n\n<p>Let\u2019s look at two different types of businesses:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>A <strong>Goods<\/strong> Business: Pizza Shop.<\/li><li>A <strong>Service<\/strong> Business: Freelance Web Design Agency.<\/li><\/ul>\n\n\n\n<p>These examples will illustrate how <strong>Intrinsic Valuation <\/strong>functions exactly the same way for a <strong>Business <\/strong>as it does for a <strong>House<\/strong>.<\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"720\" height=\"405\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_4.png\" alt=\"An Illustration showing a comparison of a Pizza Shop and a Web Design Agency\" class=\"wp-image-36267\" srcset=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_4.png 720w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_4-300x169.png 300w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_4-400x225.png 400w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_4-624x351.png 624w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_4-50x28.png 50w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_4-100x56.png 100w, https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Valuation_4-600x338.png 600w\" sizes=\"auto, (max-width: 720px) 100vw, 720px\" \/><\/figure>\n\n\n\n<h3 class=\"wp-block-heading\" id=\"h-business-valuation-1-pizza-shop\"><strong>Business Valuation #1: Pizza Shop<\/strong><\/h3>\n\n\n\n<p>If we decided to start a pizza shop tomorrow, we\u2019d look to buy (or more likely Rent) a store.<\/p>\n\n\n\n<p>Once we find our store, we\u2019d also need to buy a bunch of additional items. <\/p>\n\n\n\n<p>For example, we would need <strong>ingredients for our Pizza, <\/strong>a few <strong>Ovens<\/strong>,<strong> <\/strong>and <strong>numerous other items<\/strong> to ensure the Pizza Shop can operate effectively. <\/p>\n\n\n\n<p>Let\u2019s assume that all of this costs us <strong>$200,000<\/strong>.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1280\" height=\"720\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Asset-Value-vs-Cash-Flow-Value-Pizza-Shop.gif\" alt=\"A GIF showing the Asset Value and Cash Flow Business Valuation Methods for a Pizza Shop\" class=\"wp-image-39497\"\/><\/figure><\/div>\n\n\n\n<p>Let\u2019s say that our pizza shop is a <strong>MAJOR<\/strong> success and people can\u2019t get enough of our pizza. In our first year, we generate a cash profit of <strong>$400,000<\/strong>.<\/p>\n\n\n\n<p>Now, let&#8217;s fast forward to the end of year one. <\/p>\n\n\n\n<p>Someone approaches you and offers to pay <strong>$200,000<\/strong> for the <strong>Business <\/strong>since that\u2019s what you initially paid for it (i.e. the <strong>Asset Value<\/strong>).<\/p>\n\n\n\n<p style=\"font-size:27px\"><strong>Would you take the offer?<\/strong><\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1280\" height=\"720\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/Scale-Pizza-Shop.gif\" alt=\"A GIF showing that Cash Flow Value vs Asset Value Business Valuation Methods on a scale, highlighting that in Cash Flow Value is higher\" class=\"wp-image-39498\"\/><\/figure><\/div>\n\n\n\n<p>Nope! You\u2019d probably laugh them out of your store and go back to selling pizza. &#x1f60a;<\/p>\n\n\n\n<p>Hold that thought and let&#8217;s take a look at our next business. <\/p>\n\n\n\n<h3 class=\"wp-block-heading\" id=\"h-business-valuation-2-freelance-consulting\"><strong>Business Valuation #2: Freelance Consulting<\/strong><\/h3>\n\n\n\n<p>Now, let\u2019s imagine that you start a <strong>Freelance Web Design Agency<\/strong>. You hire 10 people to help you with the workload.<\/p>\n\n\n\n<p>For this, you\u2019ll need to buy <strong>Computers <\/strong>for all of your employees and any necessary software for web design. <\/p>\n\n\n\n<p>Let\u2019s assume that all of this costs you <strong>$50,000<\/strong>.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1280\" height=\"720\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/5-Asset-Value-vs-Cash-Flow-Value-Web-Agency.gif\" alt=\"A GIF showing Asset Value and Cash Flow Business Valuation Methods for a web design agency\" class=\"wp-image-39500\"\/><\/figure><\/div>\n\n\n\n<p>As was the case with the Pizza Shop, let\u2019s imagine that your <strong>Business <\/strong>takes off like a rocket! <\/p>\n\n\n\n<p>You make <strong>$200,000<\/strong> in one year and see even more potential to grow going forward.<\/p>\n\n\n\n<p>Again, someone approaches you to buy the business. They offer <strong>$50,000<\/strong> since that&#8217;s what you paid to start the <strong>Business<\/strong>.  <\/p>\n\n\n\n<p style=\"font-size:27px\"><strong>Would you sell the business for the same $50,000 you paid to initially get the business started? Again, clearly not!<\/strong><\/p>\n\n\n\n<p><br><\/p>\n\n\n\n<p><\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-how-to-value-a-business-asset-vs-cash-flow\"><strong>How to Value a Business: Asset vs Cash Flow<\/strong><\/h2>\n\n\n\n<p style=\"font-size:19px\">In both cases above (as well as with our <strong>Houses<\/strong>), the future <strong>Cash Flow<\/strong> value far exceeds the <strong>Asset Value<\/strong>, and <strong><u>we\u2019ll generally defer to the higher of the two<\/u><\/strong> for <strong>Houses<\/strong>, <strong>Businesses<\/strong>, and any <strong>Cash Flow Generating Asset<\/strong>! <\/p>\n\n\n\n<p>Generally speaking, compiling a group of assets to generate a far greater cash flow than their original value is the primary objective when starting a <strong>Business<\/strong>.<\/p>\n\n\n\n<p>As we can see above, <strong>Asset Value<\/strong> tells us what we paid in the past, but <strong>Cash Flow<\/strong> <strong>Value<\/strong> tells us about the value the business will create in the future.<\/p>\n\n\n\n<p style=\"font-size:19px\">In short, <strong>Cash Flow Value<\/strong> is the underlying driver behind nearly all <strong>Business Valuation<\/strong>.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1280\" height=\"720\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/6-Asset-Value-vs-Cash-Flow-Value-Concept-1.gif\" alt=\"A GIF showing the Asset Value reflects the past and Cash Flow Value reflects the future\" class=\"wp-image-39511\"\/><\/figure><\/div>\n\n\n\n<p><\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-awesome-so-how-do-i-value-future-cash-flows\"><strong>Awesome\u2026 So, How Do I Value Future Cash Flows?<\/strong><\/h2>\n\n\n\n<p>The next natural question you might be asking is&#8230;<em><strong>How do we actually value Cash Flows?<\/strong><\/em> <\/p>\n\n\n\n<p>Especially since they both occur in the future and are unpredictable.<\/p>\n\n\n\n<p>To value <strong>Cash Flows<\/strong>, we only need two tools:<\/p>\n\n\n\n<ol class=\"wp-block-list\"><li><strong>Tool #1:<\/strong> Discounting (aka <strong>Time Value of Money<\/strong>).<\/li><li><strong>Tool #2:<\/strong> <strong>Discounted Cash Flow Analysis<\/strong> (aka <strong>DCF Analysis<\/strong>).<\/li><\/ol>\n\n\n\n<p>Let&#8217;s take a look at each of these tools in action!<\/p>\n\n\n\n<p><\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-business-valuation-tool-1-discounting\"><strong>Business Valuation Tool #1: Discounting<\/strong><\/h2>\n\n\n\n<p>To begin with, we said that the <strong>Valuation <\/strong>of a <strong>House <\/strong>or a <strong>Business <\/strong>is a function of <strong>Cash Flows<\/strong>. <\/p>\n\n\n\n<p>The issue is that <strong>those Cash Flows&#8230;exist in the future<\/strong>. <\/p>\n\n\n\n<p>And we need to value those <strong>Cash Flows<\/strong> <strong>as of today<\/strong>. <\/p>\n\n\n\n<p><strong>Discounting <\/strong>is what allows us to make this happen. <\/p>\n\n\n\n<p>The short story with <strong>Discounting<\/strong> is that if we receive cash <strong>Today<\/strong> (as opposed to in the <strong>Future<\/strong>), we can generate a return on that money in the meantime. <\/p>\n\n\n\n<p>As a result, there is a <strong><em>cost<\/em><\/strong> to receiving money in the future vs today (a concept formally called the <strong>Time Value of Money<\/strong>) because you lose the opportunity to generate a return on that money.<\/p>\n\n\n\n<p>As we go further and further into the <strong>Future<\/strong>, the cost increases. That\u2019s because we\u2019re missing out on more and more of a return that could have been generated (an <strong>Opportunity Cost<\/strong> in finance-speak).<\/p>\n\n\n\n<p><strong>Discounting<\/strong> is a process that adjusts future cash flows to reflect this cost, which <strong>basically brings the Future dollars back to today<\/strong> and allows us to <strong>value the Future<\/strong> cash flows <strong>as if we received them Today<\/strong>.<\/p>\n\n\n\n<p style=\"font-size:19px\">Don&#8217;t worry so much about the Math in the image below for now. In short, we use <strong>Discounting<\/strong> to pull <em><span style=\"text-decoration: underline;\"><strong>Future<\/strong><\/span><\/em> dollars from the future back to <em><span style=\"text-decoration: underline;\"><strong>Today<\/strong><\/span><\/em>. <\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1280\" height=\"720\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/03\/7-Compounding-vs-Discounting.gif\" alt=\"A GIF showing the discounting process used in Business Valuation \" class=\"wp-image-39502\"\/><\/figure><\/div>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-business-valuation-tool-2-discounted-cash-flow-analysis\"><strong>Business Valuation Tool #2: Discounted Cash Flow Analysis&nbsp;&nbsp;&nbsp;<\/strong><\/h2>\n\n\n\n<p>In a <strong><a href=\"https:\/\/pitchbook.com\/blog\/how-discounted-cashflow-analysis-works\" target=\"_blank\" rel=\"noreferrer noopener\"><span class=\"has-inline-color has-vivid-cyan-blue-color\">Discounted Cash Flow<\/span><\/a><\/strong> analysis, we make detailed projections of our <strong>Cash Flows<\/strong> until the business achieves a <strong>Steady-State<\/strong> <strong>Growth<\/strong> <strong>Rate <\/strong>that equals the level of growth of the overall economy. This usually takes us 5-10 years into the future for most businesses.<\/p>\n\n\n\n<p>Beyond that point, we have a few other tools to estimate the projected <strong>Cash Flows<\/strong> for all other future years. We explore these tools in detail in our Finance|able Valuation course (Coming Soon!). <\/p>\n\n\n\n<p>Once we have our projections laid out, we use the <strong>Discounting<\/strong> tool discussed above to bring the <strong>Cash Flows<\/strong> back to today.<\/p>\n\n\n\n<p>When we pull all the future <strong>Cash Flows<\/strong> of a <strong>House <\/strong>or <strong>Business <\/strong>back using <strong>Discounting<\/strong>, we will end up with a single dollar value. <\/p>\n\n\n\n<p>This single dollar value is the price we would pay for the right to receive all of those cash flows in the future.<\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1280\" height=\"720\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/06\/8-DCF-Process.gif\" alt=\"\" class=\"wp-image-39503\"\/><\/figure><\/div>\n\n\n\n<p>That single dollar value is what we would pay for the business today\u2026 or the <strong>Valuation<\/strong> of the <strong>Business<\/strong> (or <strong>House<\/strong>).&nbsp;&nbsp;<\/p>\n\n\n\n<p>In the Finance world, we need fancy terms for everything; so instead of calling this value <strong>Purchase Price<\/strong>, as you would for a <strong>House<\/strong>, we call it <span class=\"has-inline-color has-vivid-cyan-blue-color\"><strong><a href=\"https:\/\/en.wikipedia.org\/wiki\/Enterprise_value\">Enterprise Value<\/a><\/strong> <\/span>when discussing <strong>Business Valuation<\/strong>.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-wrap-up-how-to-value-a-business\"><strong>Wrap-Up: How to Value a Busines<\/strong>s<\/h2>\n\n\n\n<p>In short, the price we pay for any <strong>House <\/strong>or <strong>Business <\/strong>is basically what we would pay for the right to all the future Cash Flows of the <strong>House <\/strong>or <strong>Business<\/strong>&#8230;or any <strong>Cash Flow Generating Asset<\/strong> for that matter. <\/p>\n\n\n\n<p>To calculate this value, we would construct a <strong>Discounted Cash Flow Analysis<\/strong> which uses <strong>Discounting<\/strong> to value <strong>Future Cash Flows<\/strong> as of <strong>Today<\/strong>.<\/p>\n\n\n\n<p>Now, let\u2019s have a quick look at a few final points.<\/p>\n\n\n\n<p>First, let&#8217;s recap the components of our <strong>Mental Model<\/strong> that we&#8217;ve built thus far:<\/p>\n\n\n\n<ol class=\"wp-block-list\"><li>A <strong>House <\/strong>and a <strong>Business <\/strong>are both <strong>Cash Flow Generating Assets <\/strong>(<strong>CFGA&#8217;s<\/strong>)and share the same characteristics.<\/li><li>The underlying driver of the <strong>Intrinsic Valuation <\/strong>for nearly any <strong>CFGA<\/strong> is the value of <strong>Future Cash Flows<\/strong> <strong>Discounted<\/strong> back to today (as long as <strong>Cash Flow Value<\/strong> is greater than <strong>Asset Value<\/strong>).<\/li><\/ol>\n\n\n\n<p>Now, going back to a point made in the <a href=\"https:\/\/finance-able.com\/learn-finance-foundational-framework\/\" target=\"_blank\" rel=\"noreferrer noopener\"><span class=\"has-inline-color has-vivid-cyan-blue-color\">First Article<\/span><\/a>, you should always anchor back to the <strong>House <\/strong>analogy when you get stuck (especially in an interview!). <\/p>\n\n\n\n<p>For all of my past students, a <strong>House<\/strong> is generally easier to think through conceptually than the more abstract concept of a <strong>\u2018Business\u2019<\/strong>&#8230;especially when you&#8217;re just beginning your <strong>Finance Learning Journey.<\/strong> <\/p>\n\n\n\n<div class=\"wp-block-image\"><figure class=\"aligncenter size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1280\" height=\"720\" src=\"https:\/\/finance-able.com\/wp-content\/uploads\/2021\/06\/9-House-is-The-Best-Anchor.gif\" alt=\"A GIF showing a House and a Business, highlighting the house as the best mental anchor for Business Valuation\" class=\"wp-image-39504\"\/><\/figure><\/div>\n\n\n\n<p>As mentioned at the beginning of the article, there are <strong>Two <\/strong>primary <strong>Business Valuation Methods:<\/strong> <strong>Intrinsic Valuation <\/strong>and <strong>Multiple-Based Valuation<\/strong>. <\/p>\n\n\n\n<p>In <strong>Article #3<\/strong>, we\u2019ll continue our discussion of common <strong>Business Valuation Methods<\/strong> with a similar walkthrough of <strong>Multiple-based Valuations<\/strong>. Stay tuned and hope to see you soon!<\/p>\n\n\n\n<p>Please let us know if you have any comments or questions below.<\/p>\n\n\n\n<p><\/p>\n\n\n\n<h3 class=\"wp-block-heading\" id=\"h-related-links\"><strong>Related Links<\/strong><\/h3>\n\n\n\n<ul class=\"wp-block-yoast-seo-related-links\"><li><strong><span class=\"has-inline-color has-vivid-cyan-blue-color\"><a href=\"https:\/\/finance-able.com\/the-world-of-finance\/\" target=\"_blank\" rel=\"noreferrer noopener\">The World of Finance<\/a><\/span><\/strong><\/li><li><strong><span class=\"has-inline-color has-vivid-cyan-blue-color\"><a href=\"https:\/\/finance-able.com\/the-world-of-finance\/\" target=\"_blank\" rel=\"noreferrer noopener\"><\/a><a href=\"https:\/\/finance-able.com\/mental-model-how-houses-businesses-stocks-work\/\"><\/a><a href=\"https:\/\/finance-able.com\/learn-finance-foundational-framework\/\">Learn Finance ASAP #1 &#8211; The Foundational Framework<\/a><\/span><\/strong><\/li><\/ul>\n<style 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