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.