Valuation, the idea
A business is worth the cash it will produce for its owners, discounted for the fact that money later is worth less than money now. Every valuation method is an approximation of that one sentence, including the lazy ones.
Chapter 16 · Advanced
Fifteen chapters of what a business is. Seven on what it is worth.
The one sentence
A business is worth the cash it will produce for its owners over its life, discounted back to today.
Everything else — P/E, EV/EBITDA, price to book — is a shorthand for that, and each shorthand works by assuming away part of it. Knowing what each one assumes is how you know when it breaks.
Why discount at all
A rupee today is worth more than a rupee in five years, for three separate reasons.
You could have invested it. Five years of a safe return is forgone by waiting.
It might not arrive. Future cash flows are forecasts, and some do not happen.
Inflation. Chapter 7 of Finance 101: the same rupee buys less later.
The discount rate bundles all three. A higher rate means the future is worth less today — because the alternative return is higher, or the cash is less certain, or both.
The arithmetic in its simplest form
A business producing a constant ₹100 crore a year for ever, discounted at 10%:
value = cash flow ÷ discount rate = 100 ÷ 0.10 = ₹1,000 crore
At 8%:
100 ÷ 0.08 = ₹1,250 crore
Two percentage points moved the value 25%, with nothing about the business changing at all.
That is not a flaw in the method; it is a true statement about how much value depends on the cost of capital. It is also why markets re-rate when interest rates move — chapter 2 of the equity subject's "opinion changed" has a mechanism, and this is it.
Adding growth
If the cash flow grows at a constant rate for ever:
value = cash flow ÷ (discount rate − growth rate)
₹100 crore growing 4%, discounted at 10%:
100 ÷ (0.10 − 0.04) = ₹1,667 crore
Two features of that formula are worth internalising, because they explain most valuation arguments.
Small changes in the denominator move the answer enormously. Growth of 5% instead of 4% gives ₹2,000 crore — a 20% increase from one percentage point.
Growth cannot exceed the discount rate. The formula breaks, and so does the economics: a business growing faster than the economy for ever would eventually be the economy.
So any valuation resting on a long-run growth assumption near the discount rate is resting on an assumption that cannot be true. This is the most common way a model produces a number its author then believes.
Where multiples come from
Rearrange the perpetuity formula and divide both sides by earnings, and you get a multiple. That is all a P/E is — a compressed statement about growth, risk and how much cash the earnings turn into.
Which makes the relationship explicit:
Higher growth justifies a higher multiple. More cash later.
Lower risk justifies a higher multiple. A lower discount rate.
Better cash conversion justifies a higher multiple. Chapter 14: earnings that become cash are worth more than earnings that do not.
A multiple is therefore not a shortcut around discounted cash flow. It is discounted cash flow with the assumptions hidden, and chapters 17 to 19 are mostly about what each one hides.
Two things valuation is not
Not precision. A model giving ₹1,247 crore is giving false comfort. The honest output is a range, and the useful question is whether today's price sits inside or outside it.
Not a prediction of the price. Chapter 2 of the equity subject: the multiple can move for years in either direction regardless of value. Valuation tells you what you are getting for your money, not when anyone else will agree.
What it is for
One thing, and it is enough.
At today's price, what does this business have to do for me to earn a reasonable return?
If the answer is "grow 6% and maintain its margins", that is a judgement you can form. If the answer is "grow 25% a year for a decade while expanding margins", you now know precisely what you are betting on — and chapter 21's reverse DCF is how you extract that answer without building a model at all.
The point
A business is worth its future cash to owners, discounted. The discount rate carries the alternative return, the uncertainty and inflation, and small changes in it move value a lot. Multiples are that same calculation with the assumptions hidden. The output is a range and a question: what must this business do, at this price, for the purchase to work?
Check yourself
4 questions. Every answer is explained afterwards, including the ones you get right — guessing correctly is not the same as knowing. Score 70% or more and the chapter is marked done.
Question 1 of 4
0 of 4 answered. You can submit with questions unanswered — they simply score zero.
Now do it with your own numbers
Take a business producing ₹100 crore a year for ever with no growth. At a 10% discount rate, what is it worth? Then at 8%. Note how much the value moved for a two point change.
A perpetuity is cash flow divided by the discount rate. The move from 10% to 8% is a 25% increase in value with nothing about the business changing.