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
Finance allah shmoop what is the dividend discount model Well
it's a technique used to value companies or at least
it wass in the stone age And yet in the
nineteen fifties maybe which basically says that a company's value
is fully contained in the cash dividends it distributes back
to invest doors This model is only useful really for
its historical relevance We we just don't use that much
these days Yeah back in the old timey cave man
days when there was essentially no research of real merit
being done on the performance of investments of whatever flavor
the dividend discount model was the best thing investors had
to value an investment in a company And remember in
those days companies paid rial dividends that were a meaningful
percentage of the total value of the company Unless so
a company pays a dollar a share this year in
dividends Historically it's raised dividends at about three percent a
year like paid a dollar last you'd expect two dollars
three next year in dollars six and change the next
so well The dividend discount model discounts backto present value
And yes we have an opus on what president value
Means but here's the logline definition present value of all
future cash flows discounted for risk in time Back to
cars Yeah that thing well a few odd things are
worth noting in this horse and buggy era formula The
dividend discount model ignores the terminal or end value of
the company Like say twenty years from now the company
is sold for cash The dividends are all that are
really focused on though in our model that seem strange
to you Well maybe But let's say the discount rate
is ten percent in the risk free rate is four
percent for a total of fourteen percent a year discounted
back to the present So doing the math just looking
at the terminal value of say a hundred million bucks
in a sale to be made twenty years from now
Let's figure out what that's worth today Well you take
the one point one four Put it to the twentieth
power to reflect twenty years of discounted valuation compounding And
you say one point one four forty twenty powers about
thirteen point seven So to get the present value of
one hundred million bucks twenty years from now using this
discount rate Will you divide the hundred million by thirteen
point seven and that means that the one hundred million
dollars twenty years from now today is worth only seven
point three million bucks And yeah that's ah big haircut
kind of like this guy Well the formula focuses ah
lot on near term dividend distribution and it's Really more
interesting is a relic of original financial research in theory
than anything directly useful today And if you find this
interesting while then we may have a gig for you
here at shmoop finance central Yeah come on down We 00:02:39.715 --> [endTime] need writers good ones not like me
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