Discount Factor

Finance allah shmoop What is discounted Cash flow money air

gets your money on sale discounted money Yeah kind of

sort of like that but how can cash be discounted

and what is flowing anyway Is this like a scene

from huck finn goes to wall street so the cash

we're talking about here is cash in the future Got

it Your company the spice in ator ink sells a

product that takes any item of food and runs it

through a processor which makes it pumpkin spice flavor You

are hated by starbucks everywhere So spice in aitor is

going to make ten grand by the end of this

year Fifty grand by the end of next year and

for five hundred grand by the end of the following

year and a million bucks by the end of the

next All right that's not revenues that's profit Or at

least so you you think it's going to earn a

million bucks you estimate you guess you hope All right

Well the value of a company in professional wall street

he circles is the sum of the parts of its

future cash flows or cash profits than discounted back for

risk Meaning it might not actually earn that million dollars

in four years and time What if those forty years

or ten years or two years Alright all this means

that spice in ator ink earning half a million bucks

in three years is an estimated number It's not certain

it's hope for begged for prayed for even at least

in the red states but there is risk It doesn't

happen Maybe there's thirty percent on that produces three hundred

grand in profits instead of five hundred grand but ten

percent odds It produces a million dollars instead of that

five hundred grand and years out So calculating that risk

and then discounting it in the value of the company

Today is a big part of valuing a business parts

that's the risk side But then there's the time side

you have to think about as well If you had

a company you were certain would make half a million

dollars in profit thirty years from now you know like

shmoop well that wouldn't be as impressive or valuable as

a company You were equally certain would make half a

million dollars in profit next year So that's the time

component let's add up the notional value of this company

just as an illustration here Alright Your company's spice in

ater at the moment has no cash your debt and

is for illustrative purposes on lee So don't get all

technical on us and wine about details Try to glean

a concept here okay So spicy nature will make ten

thousand Dollars this year in profits it's january now in

twelve months were eighty percent certain it'll make ten grand

in profit All right now if we bought the safest

bond in the world a one year u s treasury

bond we get three percent interest We fight a discount

on a thousand bucks Okay that number's serves as kind

of a bassline whenever we do these kind of analyses

the u s treasury paper is in generally riskless question

how much riskier is our company Above and beyond the

t bill I even company makes that ten thousand dollars

like could it only make five thousand sure couldn't make

nothing couldn't lose money Sure couldn't make way more than

ten grand maybe twenty thirty forty grand Regardless there is

risk here So the value of that ten thousand dollars

a year from now carries what is called a risk

premium tacked onto that three percent figure We're gonna divide

by it So adding risk premium makes the present value

less All right let's say that extra risk is pretty

high like twelve percent That company produces meaningfully less than

ten grand and profits All right well we discount back

that One year from now figure of ten thousand dollars

to be less right Well here's the math you take

the amount expected to be earned Yes that is the

cash flow ding ding ding and you divide by one

plus the quantity of the risk free rate that t

bill three percent thing plus the risk premium which we've

guest is in twelve percent So what is the risk

adjusted and discounted cash flow of ten thousand dollars expected

or estimated a year from now worth today Well it's

ten grand divided by the quantity one plus point zero

three plus point one teo or divided by one point

one five to the first power for this one year

away and it looks like that which equals a bit

under eighty seven hundred bucks So wow Interesting It means

that the risk of getting that ten grand a year

from now is high In fact it is worth roughly

thirteen hundred bucks less today Because of that risk or

set another way our analysis would suggest that you'd be

risk neutral if you took a cashier's cheque today for

eighty seven hundred bucks versus waiting a year and getting

that Ten grand pay then But if you did wait

well you'd have a very nice fifteen percent ish return

on your invested money All right Welcome to risk people

This is investing Wanna one's order and no extra charge

from the kindly loving people it's mum inside All right

And as you'd guess you can get to the total

value of the company by adding up and then discounting

future years cash flows of this company in the same

way when we have the ten grand number already What

about the fifty k two years from now Well since

we are comp pounding investment returns we make a call

too Exponents land with e ticket there all day passed

And to discount the odds of that fifty k coming

to us two years from now we apply a similar

calculation on lee Now we think that the odds of

fifty k in two years are even riskier than they

were before Will attach a seventeen percent risk premium toe

actually getting out fifty grand a profit out of our

product And we have to discount it back on top

of the safe or risk free rate of three percent

Well how's that work well we have fifty thousand bucks

coming to us We think and hope and pray two

years from now We then divided by one plus point

zero three plus the risk premium of point one seven

squared or to the second power Why Because it's two

years of compounding away not one Remember I kind of

mumbled that one year to the first power thing was

clever on Alright that's Fifty grand over the quantity One

point two square or fifty grand over one point four

four or carrying a present discounted value of fifty k

divided by that one point four four which is a

little under thirty five grand Well if we carry this

forward a year and there's even more risk for the

fur five hundred thousand bucks we expect in three years

Well then we get something like a risk premium of

say twenty two percent tacked onto the safe rate of

three percent or twenty five percent total And we discounted

back three years or cubed if it looks like this

Five hundred thousand dollars divided by the quantity one plus

point oh three plus point two two to the third

power Or that's five hundred thousand dollars over one point

two five cubes Which is almost to telling us that

the present value of that highly suspect five hundred k

in profits supposedly coming in from spice in ator was

about five hundred thousand over too or just over two

hundred fifty grand in present value today Got it Well

same holds true for that million dollar year and calculate

the discounted cash value of that million bucks four years

from now you follow the same pattern and add in

the million bucks divided by the quantity one Plus you

know all the other crap in there Yeah So if

we're getting the total discounted cash flow valuation of the

company we just add everything up including a sale of

the company at the end Like if we sold it

for two and million dollars six years from now we

discount that back with some you know premiums and someone

loaded in so that ten million's not a sure thing

at all We have to assume our guests or dark

board with blindfolds on the value of the company overall

will hold for five years from now And yeah that's

How This kind of cash flow works at least the

one point overs you're learning here So just be careful

when you throw that dart You don't want to force

your business partners to rock and ipad shit no matter 00:07:57.755 --> [endTime] how much that looked cool Oh