2.2.1 · 40–60 minutes · read, calculate, discuss, review
What you will learn
- Distinguish a share price from an estimated value.
- Choose an appropriate valuation approach.
- Explain why a strong company can be an unattractive investment.
2.2 · Valuation
Define the cash flow
Valuation · the work you will do
- 1Define the cash flow
- 2Make assumptions explicit
- 3Estimate a range
- 4Compare with price
Before you begin
You love a company’s products. Its shares cost £8. What would make £8 a reasonable price rather than simply a familiar number?
Write your first response before continuing.
Video coming soon · about 4 minutes
Introduction to Valuation
Use the narration below while the recording is being made, then try the decisions in this lesson.
Read the full narration
Welcome to On Judgement. You love a company’s products. Its shares cost £8. What would make £8 a reasonable price rather than simply a familiar number? Take a first view. You can change it when you have considered the evidence.
A market price records the terms on which shares trade. A valuation is an estimate based on future benefits, resources, risk and required returns. Investors can share the same historical data yet disagree about growth, margins, reinvestment and uncertainty. An estimated value is conditional, not a fact waiting to be discovered with enough decimal places. Always state the claim being valued and the date.
Ordinary shareholders have a residual claim after obligations to other providers of capital. Their returns can include distributions and a later sale, with losses possible. Market capitalisation values the equity at the observed price. Enterprise value is a bridge to operating value across capital providers under stated adjustments. Do not compare an enterprise estimate directly with a per-share price or subtract debt twice.
Relative valuation compares compatible price or enterprise multiples. DCF converts forecast cash flows into present value. An asset-based approach adjusts relevant assets and obligations, which may differ from accounting book values. Sum of the parts values distinct operations separately and makes corporate adjustments. Use the method that fits the question and available evidence; more methods do not help if their inputs are equally unsupported.
An excellent product does not justify an unlimited share price. High growth can already be priced in; investment needed to achieve it can absorb cash. A low multiple can reflect genuine risk rather than a bargain. Start a valuation by documenting the business case, value drivers and competing explanations. End with a range, a comparison with price and the evidence that could change your conclusion.
Let's work through From price to enterprise value · Harbour, £m. Harbour has 20m shares at £8 each, debt 50 and cash 30. Assume all cash is excess, there are no other claims or non-operating assets, and book equity is 100. Pause here and try the calculation or reasoning before continuing.
Market equity value = £8 × 20m = £160m. Simplified enterprise value = 160 + 50 − 30 = £180m. Price/book = 160/100 = 1.6x; book value per share = 100/20 = £5.
£5 book value does not establish intrinsic value. The gap may reflect future earning power, unrecorded assets, risk or a mistaken market view.
Now try the choices in this lesson. If your answer changes, identify the reason. Explain why a strong company can be an unattractive investment. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.
A price is an observed exchange
A market price records the terms on which shares trade. A valuation is an estimate based on future benefits, resources, risk and required returns. Investors can share the same historical data yet disagree about growth, margins, reinvestment and uncertainty. An estimated value is conditional, not a fact waiting to be discovered with enough decimal places. Always state the claim being valued and the date.
Value belongs to a claim
Ordinary shareholders have a residual claim after obligations to other providers of capital. Their returns can include distributions and a later sale, with losses possible. Market capitalisation values the equity at the observed price. Enterprise value is a bridge to operating value across capital providers under stated adjustments. Do not compare an enterprise estimate directly with a per-share price or subtract debt twice.
Four approaches in the toolkit
Relative valuation compares compatible price or enterprise multiples. DCF converts forecast cash flows into present value. An asset-based approach adjusts relevant assets and obligations, which may differ from accounting book values. Sum of the parts values distinct operations separately and makes corporate adjustments. Use the method that fits the question and available evidence; more methods do not help if their inputs are equally unsupported.
Price still matters
An excellent product does not justify an unlimited share price. High growth can already be priced in; investment needed to achieve it can absorb cash. A low multiple can reflect genuine risk rather than a bargain. Start a valuation by documenting the business case, value drivers and competing explanations. End with a range, a comparison with price and the evidence that could change your conclusion.
From price to enterprise value · Harbour, £m
Harbour has 20m shares at £8 each, debt 50 and cash 30. Assume all cash is excess, there are no other claims or non-operating assets, and book equity is 100.
- Market equity value = £8 × 20m = £160m.
- Simplified enterprise value = 160 + 50 − 30 = £180m.
- Price/book = 160/100 = 1.6x; book value per share = 100/20 = £5.
£5 book value does not establish intrinsic value. The gap may reflect future earning power, unrecorded assets, risk or a mistaken market view.
Put it into practice
1. Choose the approach
Suggest useful starting methods for a property holding company, a stable operating company, a peer-rich retailer and a two-division group.
Record your response in your workbook before opening feedback.
Compare with a model response
Adjusted assets may help the property owner; DCF may help the operating company; multiples can cross-check the retailer; SOTP can illuminate divisions. Each choice needs relevant inputs and other evidence.
2. Rank evidence
Compare a viral post, customer retention data, audited historical profit and a justified cash forecast as valuation inputs.
Record your response in your workbook before opening feedback.
Compare with a model response
The post is a lead; retention supports a business mechanism; historical profit anchors the model; forecast cash connects assumptions to value. None is sufficient without reliability, context and price.
3. Explain a great business
Write a paragraph showing how a very successful business might still disappoint a shareholder buying today.
Record your response in your workbook before opening feedback.
Compare with a model response
Its future success may be more than reflected in price; reinvestment, dilution, discount rates or competition can reduce returns. Show a mechanism rather than assume product quality equals share performance.
Jargon buster
Price
An observed transaction or quoted market amount.
Estimated value
A conditional estimate of a claim’s worth.
Market capitalisation
Share price multiplied by the relevant share count.
Enterprise value
A defined operating-value measure bridged from equity and other claims.
NAV
Net asset value under a stated measurement basis.
Valuation range
Outputs from justified assumptions, not automatically a probability interval.
Knowledge check
Make each choice on the page. Feedback explains the reasoning. Use Try again after revisiting an idea.
AQA connection and further reading
AQA 7138 connections: 3.1.4 financial management, 3.3.3 strategy/investment appraisal, 3.3.4 change and uncertainty; Annex 6 quantitative interpretation; AO2–AO4 application, analysis and evaluation. Enterprise DCF, WACC, trading multiples and SOTP are investing enrichment, not prescribed AQA company-valuation methods.
AQA 7138 specification
Primary curriculum mapping; teacher interpretation, not endorsement.
IAS 7 overview · IFRS Foundation
Accounting classification context. Presentation changes and effective/adoption dates must be checked for real reports.
Free Cash Flow Valuation · CFA Institute
Technical cross-check for consistent claims and valuation formulas; advanced optional reading.
Introduction to Valuation · Aswath Damodaran, NYU
Optional deeper reading on valuation approaches.
Take forward
Distinguish a share price from an estimated value. Choose an appropriate valuation approach. Explain why a strong company can be an unattractive investment.