Nobody really needs it, but almost everybody knows E=MC²—Einstein’s formula for relativity. It’s a concept that sticks, even if most people don’t fully understand it. The same could be said about valuing companies.
From Discounted Cash Flow (DCF) models to multiples-based approaches and asset valuations, countless methods claim to crack the code for determining value. But when you strip away the noise, only three elements truly matter: cash flow, risk, and growth.
No matter how advanced or creative valuation models appear, they all lead back to these fundamentals. Let’s break it down.
The Formula of Value
There’s no single formula that perfectly captures how businesses should be valued. However, a conceptual framework often cited in finance is:
V = C / (r-g )
Where:
- V = Value of the business
- C = Cash Flow (the company’s ability to generate earnings)
- g = Growth rate (the potential to expand future cash flows)
- r = Risk (the uncertainty surrounding future earnings)
Unlike Einstein’s equation, this isn’t a strict mathematical law—it’s more of a guiding principle. It helps you think about valuation in terms of how these three factors interact.
In a nutshell: Company Value, V, increases if C,cash flow, gets bigger. Other things being equal, if expected cash-flow is the same, but the growth rate increases, then the value also rises. Finally, if the Risk rises for a given cash-flow projection, then that Value becomes smaller.
The Three Pillars of Valuation
Cash Flow – The Foundation
Cash flow is the lifeblood of any business. It represents how much money the company generates and how easily it converts revenue into cash. Higher cash flow often signals a healthier, more valuable business.
Risk – The Uncertainty
Risk reflects the likelihood that future cash flows might fall short of expectations. Factors like economic conditions, market competition, and regulatory changes can increase risk, lowering the perceived value of a company.
Growth – The Potential
Growth measures how much a company’s earnings or operations can expand over time. High-growth businesses often justify higher valuations, especially when future profits are expected to rise significantly.
Why These Factors Matter Most
Market Size and Competition
A large, less competitive market can drive higher cash flows and lower risk, boosting overall value.
Management Expertise
A skilled management team improves efficiency, reduces risk, and fosters growth, strengthening all three valuation drivers.
Economic Conditions
A strong economy can stimulate cash flow and growth while reducing risk. In contrast, economic downturns have the opposite effect.
Technological Advancements
Innovations can disrupt industries, creating opportunities for growth while introducing risks for companies that fail to adapt.
Regulatory Environment
Laws and regulations can increase costs or limit market access, affecting cash flow, growth, and risk simultaneously.
Simplifying Valuation Thinking
Despite the endless list of valuation elements, understanding this trifecta simplifies the process. To increase the value of a company one always has to look at its implications of all three aspects. For example increasing profits may not be worth it, if perceived risk is also increasing. Here are a couple of exmpales?
- Is it worth increasing cash flow if associated measures also increase risk?
- Can it be worth reducing cash flows if we also reduce risk with it?
- Is expected growth worth increasing, if the associated risk also increases?
By answering these questions, investors can make informed decisions without drowning in financial complexity.
Real-World Applications
While theoretical models like DCF are useful in classrooms, practical business valuations often take a more straightforward approach. Investors and buyers tend to focus on multiples and comparables because they implicitly account for cash flow, risk, and growth—without complex calculations.
Conclusion
Valuing companies doesn’t have to be complicated. At the end, complex models also depend on the future and is it worth using a complex model when you have no reliable forecast for the future? At its core, every valuation boils down to three simple factors cash flow, risk, and growth. Whether you use DCF models, multiples, or asset-based methods, these fundamentals drive the outcome.
By focusing on this trifecta, investors can cut through the noise, avoid overcomplication, and develop clear, logical insights into what a business is really worth.
At FaMAS, we specialize in providing practical, real-world valuation strategies that align with the German market. Whether you’re buying, selling, or evaluating investment opportunities, we help you focus on what truly matters—cash flow, risk, and growth.
Disclaimer: This article provides general information and should not be considered financial advice.