Valuation ???
A Simple Guide with the Lemonade Stand
Introduction: How do you value a business / stock?
The Concept: Buying a stock isn't like buying a lottery ticket; it’s like buying a machine that prints money over time. A valuation exercise is simply calculating what that machine is worth today based on all the cash it will print in the future.
If you add up all those future cash payments—and adjust them for the risk that you might not actually get them—you get the Fair Value of the business. That is all a valuation is: the sum of the future cash flows, valued in today's dollars.
1. From Revenue to Operating Margin
The Concept: Revenue is just the top line—it's how much money comes in the door. But value is created by what is left over after paying the bills. Operating Margin tells us how efficient the business is at turning sales into profit.
You spent $200 on lemons, sugar, and cups.
You paid $200 for labors and permits.
The Math:
$1,000 (Revenue) - $400 (Expenses) = $600 Operating Income.
To get the Operating Margin, we divide income by sales: $600 / $1,000 = 60%.
In the App: When you adjust the Operating Margin, you are asking: "For every dollar this company sells, how many cents do they keep as profit?"
2. Reinvestment Rate
The Concept: Growth is expensive. To make more money, you usually have to spend money (on factories, software, or inventory). The Reinvestment Rate measures efficiency: For every $1.00 you invest in the business, how much new revenue do you generate?
Scenario A (More Efficient): Your Reinvestment Rate is 2.0. To get $500 of new revenue, you divide by 2.0. $500 Growth / 2.0 Ratio = $250 Reinvestment required.
Scenario B (Less Efficient): Your Reinvestment Rate is 1.0. To get $500 of new revenue, you divide by 1.0. $500 Growth / 1.0 Ratio = $500 Reinvestment required.
In the App: If you lower the Reinvestment Rate input, you are saying the company will become less efficient, meaning they have to burn more cash just to grow at the same speed. This lowers the value of the company.
3. Cost of Equity (Required Return)
The Concept: Money has a cost. If you invest in a risky stock, you expect a higher return than if you put your money in a safe savings account. The Cost of Equity is the minimum return you require to justify the risk.
The Safe Option: He could buy a government bond that pays him 4% guaranteed.
The Risk: Your stand is risky. It might rain all summer. The price of lemons might triple.
Because of this risk, he won't give you money for a 4% return. He tells you: "I need at least a 10% return to make this risk worth it." That 10% is the Cost of Equity.