DCF II : Where is the Money Coming From?

I started discussing how to Discount Cash Flows, and why it’s helpful for anyone who wants to value a business, especially for investment purposes. You can read the first post here.

Instead of diving into a DCF table immediately. let me give a bit more thought to the cash flow itself. Before you can discount future cash flows to the present, your first job is to determine if those anticipated cash flows are actually likely to materialize. There’s no point valuing a company on future money it will never make.

A pretty universal understanding is that businesses make money from exploiting market inefficiencies. If a market is efficient, no one would make money from it. So your first task as an analyst is to ask yourself: what inefficiency is this business counting on to make money? In my last example, I used your friend’s dry cleaning business. If he’s going to make a million plus in earnings over the next five years then several questions become important.

First, how many people live in the area his business is located in? It’s good if it’s a lot, not good if it’s barely anyone. It’s good for both counts if no matter what the current population is, the area is growing fast and people are moving in.

How many of those people tend to need dry cleaning? If much of the people are relatively white collar types, relatively busier than normal, and more well off than not, then it’s good for your friend’s business. If not, then it’s not.

How many other dry cleaners are there in the area? It’s good if it’s none, and bad if there is one on every block.

How hard will it be for someone to come in and set a drycleaning business up? It’s good if it’s hard and not good if it’s easy.

Overall, these questions are generally intuitive for most people. You might think you don’t know what makes a good business, but like that famed definition of pornography, you might not be able to describe it, but you know one when you see it. Once you can systematically think of what builds up an advantage for a business, then you’re better able to predict what it’s earnings should be and then learn how to discount them.

Once you do that,the manual discounting process becomes relatively easy.

Advertisements

One thought on “DCF II : Where is the Money Coming From?”

What do you think?

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s