Intrinsic Value, Part 1: The Cash a Business Generates
The first post in the Intrinsic Value series. No math yet — just the ideas you need before the numbers make sense.
In the introduction to this blog, I said that value investing comes down to one question: what is a business actually worth?
And I gave you the short answer: a business is worth the cash it is expected to generate in the future. That’s the whole foundation. Everything else — every formula, every ratio, every line of financial data — is just a way of making that idea precise.
Let’s build on it.
Why Cash, Not Profit?
The first thing to nail down is what we mean by cash.
Companies report a number called net income — commonly called “profit” or “earnings” — at the bottom of their income statement (a financial report summarizing what a company earned and spent over a period of time). Net income gets a lot of attention. It’s what the headlines report when earnings season rolls around.
But net income is an accounting number, not a cash number. Accounting rules give companies flexibility in how they recognize revenue (record sales) and how they spread costs over time. A company can report strong profits while actually consuming cash. It can also report weak profits while generating plenty of it.
Cash flow is different. Cash either comes in the door or it doesn’t. You can’t manufacture it with an accounting adjustment.
The specific cash flow measure we care about is called Free Cash Flow — the cash a business generates after covering everything it needs to keep operating and growing. “Free” means it isn’t already spoken for. It’s cash the business has generated beyond what it needs to sustain itself.
How Free Cash Flow Is Built
Free cash flow starts with the operating profit of the business — the money it earned from running its operations, before paying interest on debt or income taxes. We call this EBIT, which stands for Earnings Before Interest and Taxes. It’s the best single number for what the business itself produced, independent of how it’s financed.
From there, we apply taxes to get the after-tax version. Then we make three adjustments:
Add back depreciation and amortization. When a company buys a piece of equipment, accounting rules spread that cost over the equipment’s useful life — a little charge each year called depreciation (for physical assets) or amortization (for intangible assets like patents or software licenses). This is a real cost when the equipment is purchased, but in any given year it’s a bookkeeping charge, not cash going out the door. So we add it back.
Subtract capital expenditures. This is the actual cash a company spends on equipment, buildings, technology, and other physical investments to keep the business running and growing. Unlike depreciation, this is real cash leaving the company. We use a five-year average to smooth out years where a company made a large one-time purchase.
Adjust for changes in working capital. Working capital is the difference between what a company is owed by customers and what it owes to suppliers — the short-term assets and obligations that keep the business running day to day. When a business grows, it typically needs to tie up more cash in working capital (more inventory, more outstanding invoices). That’s a use of cash that doesn’t show up in profit but matters for free cash flow.
Put it together and the formula looks like this:
Free Cash Flow = After-Tax Operating Profit − Capital Expenditures + Depreciation − Change in Working Capital
That number — arrived at from real financial statements — is our starting point for valuing the business.
From One Year to the Future
Here’s the challenge: that calculation gives us free cash flow for one year, based on financial statements we already have. But we established that a business’s value depends on its future cash flows, not its past ones.
So we have to do something harder. We have to estimate what the business will generate going forward — for the next five years in detail, and then in broad strokes after that.
Three things determine what those future cash flows look like.
Determinant 1: Growth
How fast will the company’s cash flows expand?
Growth matters enormously to value. A business generating $100 million in free cash flow this year and growing at 20% per year will be worth far more than one generating the same $100 million and growing at 3%.
But not all growth is created equal. Growth that requires a lot of investment — new factories, heavy research spending, large acquisitions — is less valuable than growth that comes cheaply. The question isn’t just how fast the company is growing; it’s how much it has to reinvest to sustain that growth, and what it earns on those reinvestments.
We calculate growth the same way a business does: you can only grow as fast as you reinvest, and you only create value when those reinvestments earn more than they cost. A company that plows 60% of its earnings back into the business and earns a 25% return on those investments has a fundamentally sound growth rate. A company that reinvests just as much but earns only 6% on it is spinning its wheels.
Determinant 2: Risk
How certain are we that those future cash flows will actually materialize?
Not all cash flows are equally reliable. A utility company that provides electricity to a captive customer base generates highly predictable cash flows year after year. An early-stage technology company in a fast-changing market faces far more uncertainty.
Risk affects value through something called the discount rate — the rate we use to convert future cash flows into today’s dollars. (More on this in a moment.)
The higher the risk, the higher the discount rate, and the less those future cash flows are worth today. Think of it this way: if a company promises you $100 in five years but there’s real uncertainty about whether it’ll survive that long, you’d pay less for that promise than you would for the same $100 from a rock-solid company. The discount rate is the mechanism that captures that difference.
We use a discount rate called WACC — the Weighted Average Cost of Capital — which is a blend of what the company pays for its debt (loans, bonds) and what its shareholders expect to earn. A company with higher business risk will have a higher WACC, which makes its projected cash flows worth less in today’s dollars.
Determinant 3: Terminal Value
A company doesn’t generate cash flows for five years and then disappear. It keeps going. So after we project the years we can estimate with reasonable confidence, we need a way to capture all the value that comes after.
That’s what terminal value is. It’s an estimate of what the company is worth at the end of our five-year projection window, assuming it settles into a slow, steady pace of growth — roughly in line with the long-run growth of the economy — from that point forward.
Terminal value matters more than most people expect. In a typical valuation, it accounts for 60 to 80 percent of the total result. That’s not a flaw in the method — it reflects a real economic truth. Most of a healthy company’s value comes from what it will produce over the long sweep of its future, not just the next five years.
This is also why the choice of a long-run growth rate is one of the most consequential assumptions in the model. A small change in that number can have an outsized effect on the final result. We use the risk-free rate — the yield on a 10-year U.S. Treasury bond — as our long-run growth assumption. It’s conservative by design. Assuming a business will eventually grow no faster than the economy is a reasonable floor for a healthy company, and it prevents the kind of optimistic assumptions that lead to inflated valuations.
The Framework in One Sentence
Estimate how much free cash flow the business will generate over the next five years (driven by growth), discount those cash flows back to today’s value (driven by risk), add a terminal value for everything beyond year five, and you have the intrinsic value of the business.
That’s it. The next several posts will work through each of those pieces in detail — where the numbers come from, how they’re calculated, and where the judgment calls are.
Next: Part 2 — Why a Dollar Today Is Worth More Than a Dollar Tomorrow. Before we can calculate intrinsic value, we need to understand the idea that makes the whole model possible: a dollar you receive in the future is worth less than a dollar you hold today — and there’s a precise way to measure exactly how much less.
— Jim