How to Value a Business, And Why Almost Everyone is Doing it Wrong
Let’s start with a simple question.
If someone offered to sell you a small business, a café, a laundromat, a car wash, how would you decide what it’s worth?
You’d probably ask how much money it makes. How reliably it makes it. Whether it’s likely to make more or less in the future. And then you’d figure out how much you’d be willing to pay today for that future stream of cash flow.
That’s it. That’s valuation. Everything else is just a more complicated version of that same question.
The problem is that somewhere between that simple café example and the modern financial industry, valuation became a discipline designed to produce precise answers to questions that don’t have precise answers. And in doing so, it gave investors false confidence in numbers that are largely fictional.
Let me show you what I mean.
The Standard Approach, and Why it Often Fails
The most widely taught method of valuing a business is the Discounted Cash Flow model, the DCF. You forecast the business’s future cash flows, apply a discount rate, and arrive at a “intrinsic value” that tells you whether the stock is cheap or expensive.
In theory it’s elegant. In practice it has a fatal flaw.
The terminal value.
In a standard DCF, the terminal value, the value assigned to all cash flows beyond your forecast period, typically accounts for 70 to 90 percent of the total calculated value. Seventy to ninety percent. Which means that most of the number you’re working so hard to calculate is just a disguised assumption about what happens in year five or six and beyond.
Change one assumption, the long-term growth rate, by a single percentage point, and your “intrinsic value” changes by 30, 40, sometimes 50 percent. The precision is an illusion. You’re not calculating the value of a business. You’re laundering your assumptions through a spreadsheet.
This doesn't mean DCF is useless. It means you have to use it honestly, as a framework for thinking, not a machine for producing answers.
A Better Way to Think About it
Here’s the mental model I use instead, and the one that sits at the heart of everything I write about on The Conviction Letter.
When you buy a stock, you’re buying a claim on a business’s future cash flows. The question isn’t “what is this business worth?” in some abstract sense. The question is: how many years of today’s free cash flow are already embedded in the current price?
Let me make that concrete.
Imagine a business generating $100 million in free cash flow this year. The stock is trading at a market capitalisation of $2 billion.
That’s 20 times free cash flow. Which means at today’s earnings power, the market is asking you to pay for 20 years of cash flows upfront.
Now ask yourself: is this business likely to still be generating at least this much free cash flow in 20 years? Is it likely to generate more? And what could go wrong?
If the business has genuine competitive advantages, a long reinvestment runway, and operates in a growing market, 20 years of cash flows might be a reasonable price to pay. If it’s a cyclical business in a declining industry with a weak balance sheet, 20 years of cash flows is terrifying.
The number of years embedded in the price tells you how much has to go right for the investment to work out. The higher the number, the less room for error.
Why This Framework Matters for Beginners
If you’re new to investing, here’s what to take from this.
Don’t let anyone convince you that valuation is too complex to understand. The fundamentals are simple: you’re buying future cash flows, and the price you pay determines how good a deal you’re getting. Everything else, the models, the ratios, the financial jargon, is just different ways of answering that same question.
Start by getting comfortable with one number: free cash flow. Not earnings, free cash flow. The actual cash the business generates after maintaining and growing its operations. That’s the number that matters. Everything else can be dressed up.
Why this Framework Matters for Experienced Investors
If you’ve been investing for a while, here’s the harder truth.
Most of the time when you think you’re doing rigorous analysis, you’re actually doing elaborate rationalisation. You’ve decided you like a business, and you’re building a model that confirms it. The terminal value assumption you chose, the one that makes the DCF work, is the assumption that happens to justify the price you’re already willing to pay.
The years-of-cash-flows framework forces honesty because it starts with the current price and works backwards. Instead of asking “what is this worth?”, which invites you to construct a narrative, it asks “what does the current price assume?” That’s a much harder question to answer dishonestly.
A Word on The Simplicity of This Approach
Before we go further, an important clarification.
Dividing market capitalisation by free cash flow is a sanity check, not a complete valuation. It gives you a quick, honest starting point for understanding what the current price is assuming, but it deliberately ignores two factors that significantly affect the real answer.
The first is the growth rate of free cash flow. A business growing its free cash flow at 15% annually is worth considerably more than one generating the same cash flow today with no growth. If free cash flow is growing, the “years embedded in the price” calculation overstates how long it actually takes to justify the price, because each future year generates more cash than today.
A Practical Example
Let’s use a real business to make this tangible, Visa.
Visa generates extraordinary free cash flow. In its most recent fiscal year it produced roughly $19 billion in free cash flow on a market capitalisation of around $560 billion at the time of writing.
That’s approximately 29 times free cash flow. Nearly three decades of today’s earnings power embedded in the current price.
Is that expensive? It depends entirely on what you believe about Visa’s next 30 years.
If you believe Visa will continue displacing cash globally, growing its network, expanding into new payment categories, and compounding at high returns on capital, then 29 years of cash flows might be a reasonable price for that outcome. The business has structural tailwinds, a genuine network effect, and near-zero capital requirements.
If you think the payments landscape will be disrupted, margins will compress, or growth will slow, then 29 years of cash flows is a lot to pay for an uncertain outcome.
The framework doesn't tell you what to think. It tells you what you need to believe for the investment to make sense. That's its value.
What to Do With This?
Next time you’re looking at a stock, before you build a model or read an analyst report, do one thing:
Divide the market capitalisation by the free cash flow.
That number tells you how many years of today’s free cash flow the market is asking you to pay for. Then ask yourself honestly: does the quality of this business, its competitive position, and its growth runway justify that number?
If yes, you might have found something worth owning. If no. move on.
If you’re not sure, that’s where the real work begins.