A company's stock price bounces around every second. News, rumors, and market sentiment can send it soaring or crashing. But beneath that noise, the business itself has a more stable, underlying worth. The goal of valuation is to estimate that worth, which we call its intrinsic value.

There are two main ways to approach this problem. The first is the Market Approach, which is a bit like pricing a house. You look at what similar houses in the neighborhood have sold for and base your price on those

The second, and the focus for fundamental investors, is the Income Approach. This method treats a business as a machine that generates cash. Its value is the sum of all the cash it's expected to produce for the rest of its life. It's a more rigorous way to determine what a company is truly worth, independent of the market's mood.

The Income Approach relies on a simple but powerful concept: the time value of money. A dollar today is worth more than a dollar tomorrow. Why? Because you could invest that dollar today and earn a return on it. By the time tomorrow comes, you'd have more than a dollar.

When we value a company based on its future cash flows, we have to account for this. We can't just add up all the cash it's projected to make over the next ten years. We need to figure out what that future stream of cash is worth in today's dollars. This process is called discounting.

The discount rate, $r$, is where risk enters the equation. The higher the risk associated with a company, the higher the discount rate we apply to its future cash flows. A risky startup's promise of $1 million in five years is worth much less today than the same promise from a stable, established company. The higher discount rate reflects the lower certainty of actually receiving that cash.

When we discount all of a company's future cash flows to their present value, we arrive at a figure called Enterprise Value. This represents the total value of the entire business, including all its operations and assets. It's the value of the whole pie.

But as a stock investor, you're not buying the whole pie. You're buying a slice of it. You care about the value that's left over for shareholders after all other claims have been paid. This is called Equity Value.

To get from Enterprise Value to Equity Value, we make two simple adjustments:

1. Subtract Debt: The company's lenders have a claim on the business's assets and cash flows that must be paid before shareholders get anything. We subtract all debt and other non-equity claims.
2. Add Cash: We then add back any cash and non-operating assets (like investments in other companies) that aren't essential to the core business operations. This cash technically belongs to the owners.

Once you have the Equity Value, you can divide it by the number of shares outstanding to arrive at an estimated intrinsic value per share. This is the number you compare to the current market price to decide if a stock is potentially undervalued.

Before you dive in and test your new knowledge, let's review the key terms we've covered.

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This framework—projecting future cash flows, discounting them back to the present, and adjusting for debt and cash—is the intellectual core of modern security analysis. It provides a rational anchor in a sea of market volatility.