Discounted Cash Flow (DCF)

  

Money here! Get your money on sale! Discounted money…

Yeah, kinda sorta like that. But, uh...how can cash be discounted? And what is...flowing? Is this like a scene from Huck Finn Goes to Wall Street?

Okay, so the cash we’re talking about here is cash in the future.

Example time.

Your company, The Spicinator, Inc., sells a product that takes any item of food and runs it through a processor, which makes it pumpkin spice-flavored. You are hated by Starbucks everywhere. So Spicinator is going to make 10 grand by the end of this year, 50 grand by the end of next, 500 grand by the end of the following and a million bucks by the end of the next. Or so you think. You estimate. You guess. You hope.

The value of a company in professional Wall Street-y circles is the sum of the parts of its future cash flows…then discounted back for risk and time. Meaning that Spicinator, Inc, earning half a million bucks in three years, is estimated. It’s not certain. It’s hoped for. Begged for. Prayed for, even, at least in the red states.

But there is risk. Maybe 30 percent odds it produces 300k instead of 500k, but 10 percent odds it produces a million bucks instead of 500k. So calculating that risk and then discounting it in the value of the company today is a big part of valuing a business.

So that’s risk. But then there’s time you have to think about as well. If you had a company you were certain would make half a million dollars in profit 30 years from now…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.

Your company, at the moment, has no cash or debt, and is for illustrative purposes only, so don’t get all technical on us and whine about details. Just try to glean the concept here.

Spicinator will make 10k this year. It’s January now, and in 12 months, we are 80% certain it’ll make 10k in profits. Now if we bought the safest bond in the world, a 1-year U.S. treasury bond, we’d get 3% interest. That number serves as kind of a base line whenever we do these kinds of analyses.

Question: How much riskier is it (above and beyond the T bill) that the company makes 10k? Like…could it make 5k? Nothing? Lose money? Sure. Could it make more than 10k? Maybe. Regardless, there is risk here, so the value of that 10k a year from now carries what is called a risk premium tacked onto that 3% figure.

Let’s say that extra risk is pretty high...like 12% that the company produces meaningfully less than its 10k in profits. We’d then discount back that one-year-from-now figure of 10,000 dollars to be…less. How much less?

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 1…plus the quantity of the risk-free rate...that T-Bill thing of 3 percent)...plus the risk premium, which we’ve guessed is 12%. So what is that risk adjusted, and discounted cash flow of 10k expected or estimated a year from now...worth today? Well, it's 10 grand divided by (1 plus .03 plus .12), or 1.15, which equals a bit under 8,700 bucks.

So wow, interesting. It means that the risk of getting that 10 grand a year from now is high...in fact, it's worth roughly 1,300 bucks less today. Or said another way, our analysis would suggest that you’d be risk-neutral if you took a cashier's check for 8,700 bucks today...versus waiting a year and getting that 10 grand then.

But if you did wait, you’d have a very nice 15%-ish return on your invested money.

Welcome to risk, people.

Related or Semi-related Video

Finance: What is the Dividend Discount M...2 Views

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Finance allah shmoop what is the dividend discount model Well

00:07

it's a technique used to value companies or at least

00:11

it wass in the stone age And yet in the

00:14

nineteen fifties maybe which basically says that a company's value

00:17

is fully contained in the cash dividends it distributes back

00:22

to invest doors This model is only useful really for

00:25

its historical relevance We we just don't use that much

00:28

these days Yeah back in the old timey cave man

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days when there was essentially no research of real merit

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being done on the performance of investments of whatever flavor

00:37

the dividend discount model was the best thing investors had

00:40

to value an investment in a company And remember in

00:43

those days companies paid rial dividends that were a meaningful

00:46

percentage of the total value of the company Unless so

00:50

a company pays a dollar a share this year in

00:53

dividends Historically it's raised dividends at about three percent a

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year like paid a dollar last you'd expect two dollars

01:00

three next year in dollars six and change the next

01:02

so well The dividend discount model discounts backto present value

01:06

And yes we have an opus on what president value

01:08

Means but here's the logline definition present value of all

01:12

future cash flows discounted for risk in time Back to

01:15

cars Yeah that thing well a few odd things are

01:18

worth noting in this horse and buggy era formula The

01:21

dividend discount model ignores the terminal or end value of

01:25

the company Like say twenty years from now the company

01:28

is sold for cash The dividends are all that are

01:31

really focused on though in our model that seem strange

01:34

to you Well maybe But let's say the discount rate

01:37

is ten percent in the risk free rate is four

01:40

percent for a total of fourteen percent a year discounted

01:43

back to the present So doing the math just looking

01:45

at the terminal value of say a hundred million bucks

01:47

in a sale to be made twenty years from now

01:50

Let's figure out what that's worth today Well you take

01:52

the one point one four Put it to the twentieth

01:54

power to reflect twenty years of discounted valuation compounding And

01:58

you say one point one four forty twenty powers about

02:01

thirteen point seven So to get the present value of

02:04

one hundred million bucks twenty years from now using this

02:08

discount rate Will you divide the hundred million by thirteen

02:11

point seven and that means that the one hundred million

02:13

dollars twenty years from now today is worth only seven

02:16

point three million bucks And yeah that's ah big haircut

02:20

kind of like this guy Well the formula focuses ah

02:23

lot on near term dividend distribution and it's Really more

02:27

interesting is a relic of original financial research in theory

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than anything directly useful today And if you find this

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interesting while then we may have a gig for you

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