If you’re a beginner to investing and have never heard of the term DCF or discounted cash flow, it might sound esoteric. It’s really not. It’s simply a way of estimating the value of all the cash an enterprise will generate over it’s useful life or duration.
Let me illustrate. As an investor, what you care about is profits or money generated by your investment. Say your friend comes to you and tells you to invest in 50% of his dry cleaning business. Your first question is probably, ‘what is half of this dry cleaning business worth?’. Your friend, an eternal optimist, thinks it’s worth $1m based on it’s 5 year prospects and wants you to invest $500,0000 today. You want to be able to look at the business and, based on it’s current operations and future prospects, decide for yourself if it is worth $500,000 or not. One of the ways to do that is by discounted cashflow.
The logic is this: if your friend’s business is worth $1m, that means that it should be able to generate $1m over the course of it’s life. Now, we know that money today is worth more than money in the future. First because inflation is reducing the value of money as time goes on. Second because I can invest money today and make a return as time goes on, and third because there are several things that can happen in the future to lose you money. All of these risks and costs are captured in what is known in finance as the time value of money. So for your friend’s business to be worth $1m today, that means it has to generate not just $1m in the future, but additional money to compensate for all those risks. It’s really not an investment to put down $1m today and get $1m back after 5 years. So if your friend says the company is worth $1m today based on it’s projected earnings in the next 5 years, and inflation is 3% a year for all those years, and a reasonable investment should yield at least 10% return after inflation in 5 years, he needs to be able to show that his business can generate almost $2m at the end of the 5 years.
How does he do that?
Well, first he shows you today’s earnings, after expenses (sometimes before interest,tax and depreciation, but preferably after). How big is the current profit, and how low is the investment needed to sustain or increase it (which gives you a clue to how much free cash the business generates)? If that amount is good, then you look at the growth rate–how fast are the profits growing (they need to be increasing if not faster, then at least in tandem with inflation and risk free rate of return*), and then you consider how risky the earnings are (this is a subjective call, but the idea is to see whether those profits can be counted on to continue flowing or if they’re really fickle.) If you look at the growth, the stability of profits, and the expenses of the business, and you are reasonably certain that in 5 years, the company would have thrown out enough profits to hit that $1.86m to $2m mark and more, then perhaps you’ll feel justified to invest $500,000 at a 50% valuation.
If on the other hand, you finish looking it over, and you don’t think the business will make that kind of money, you may prefer to pass on and put your money in a Money market account where the yields are lower but at least your money will not disappear.
In another post I’ll walk through a sample DCF process to illustrate it further but it’s a useful tool for an investor to know.
The advantages isn’t just for valuation, it also helps you uncover the economic reality of a business that can be hidden by fancy accounting tricks that can lead to reporting profits for a business that isn’t really making any money.
And again, even though it sounds very esoteric, it’s really not. Hopefully, I’ll show that in my next post.
Thanks for reading. Hope you learned something.
*the return on investments that carry almost no risk like US treasuries)