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 Discounted Cash Flow?9 Views

00:00

Finance allah shmoop What is discounted Cash flow money air

00:07

gets your money on sale discounted money Yeah kind of

00:11

sort of like that but how can cash be discounted

00:15

and what is flowing anyway Is this like a scene

00:17

from huck finn goes to wall street so the cash

00:20

we're talking about here is cash in the future Got

00:23

it Your company the spice in ator ink sells a

00:30

product that takes any item of food and runs it

00:33

through a processor which makes it pumpkin spice flavor You

00:37

are hated by starbucks everywhere So spice in aitor is

00:40

going to make ten grand by the end of this

00:42

year Fifty grand by the end of next year and

00:45

for five hundred grand by the end of the following

00:48

year and a million bucks by the end of the

00:51

next All right that's not revenues that's profit Or at

00:54

least so you you think it's going to earn a

00:56

million bucks you estimate you guess you hope All right

00:59

Well the value of a company in professional wall street

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he circles is the sum of the parts of its

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future cash flows or cash profits than discounted back for

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risk Meaning it might not actually earn that million dollars

01:11

in four years and time What if those forty years

01:14

or ten years or two years Alright all this means

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that spice in ator ink earning half a million bucks

01:20

in three years is an estimated number It's not certain

01:24

it's hope for begged for prayed for even at least

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in the red states but there is risk It doesn't

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happen Maybe there's thirty percent on that produces three hundred

01:32

grand in profits instead of five hundred grand but ten

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percent odds It produces a million dollars instead of that

01:37

five hundred grand and years out So calculating that risk

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and then discounting it in the value of the company

01:44

Today is a big part of valuing a business parts

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that's the risk side But then there's the time side

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you have to think about as well If you had

01:52

a company you were certain would make half a million

01:55

dollars in profit thirty years from now you know like

01:58

shmoop well that wouldn't be as impressive or valuable as

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a company You were equally certain would make half a

02:05

million dollars in profit next year So that's the time

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component let's add up the notional value of this company

02:12

just as an illustration here Alright Your company's spice in

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ater at the moment has no cash your debt and

02:17

is for illustrative purposes on lee So don't get all

02:20

technical on us and wine about details Try to glean

02:23

a concept here okay So spicy nature will make ten

02:26

thousand Dollars this year in profits it's january now in

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twelve months were eighty percent certain it'll make ten grand

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in profit All right now if we bought the safest

02:34

bond in the world a one year u s treasury

02:37

bond we get three percent interest We fight a discount

02:41

on a thousand bucks Okay that number's serves as kind

02:44

of a bassline whenever we do these kind of analyses

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the u s treasury paper is in generally riskless question

02:51

how much riskier is our company Above and beyond the

02:55

t bill I even company makes that ten thousand dollars

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like could it only make five thousand sure couldn't make

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nothing couldn't lose money Sure couldn't make way more than

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ten grand maybe twenty thirty forty grand Regardless there is

03:08

risk here So the value of that ten thousand dollars

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a year from now carries what is called a risk

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premium tacked onto that three percent figure We're gonna divide

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by it So adding risk premium makes the present value

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less All right let's say that extra risk is pretty

03:26

high like twelve percent That company produces meaningfully less than

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ten grand and profits All right well we discount back

03:32

that One year from now figure of ten thousand dollars

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to be less right Well here's the math you take

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the amount expected to be earned Yes that is the

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cash flow ding ding ding and you divide by one

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plus the quantity of the risk free rate that t

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bill three percent thing plus the risk premium which we've

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guest is in twelve percent So what is the risk

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adjusted and discounted cash flow of ten thousand dollars expected

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or estimated a year from now worth today Well it's

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ten grand divided by the quantity one plus point zero

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three plus point one teo or divided by one point

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one five to the first power for this one year

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away and it looks like that which equals a bit

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under eighty seven hundred bucks So wow Interesting It means

04:16

that the risk of getting that ten grand a year

04:19

from now is high In fact it is worth roughly

04:22

thirteen hundred bucks less today Because of that risk or

04:26

set another way our analysis would suggest that you'd be

04:29

risk neutral if you took a cashier's cheque today for

04:32

eighty seven hundred bucks versus waiting a year and getting

04:36

that Ten grand pay then But if you did wait

04:38

well you'd have a very nice fifteen percent ish return

04:41

on your invested money All right Welcome to risk people

04:44

This is investing Wanna one's order and no extra charge

04:48

from the kindly loving people it's mum inside All right

04:51

And as you'd guess you can get to the total

04:53

value of the company by adding up and then discounting

04:57

future years cash flows of this company in the same

05:01

way when we have the ten grand number already What

05:04

about the fifty k two years from now Well since

05:07

we are comp pounding investment returns we make a call

05:11

too Exponents land with e ticket there all day passed

05:15

And to discount the odds of that fifty k coming

05:17

to us two years from now we apply a similar

05:20

calculation on lee Now we think that the odds of

05:22

fifty k in two years are even riskier than they

05:25

were before Will attach a seventeen percent risk premium toe

05:29

actually getting out fifty grand a profit out of our

05:31

product And we have to discount it back on top

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of the safe or risk free rate of three percent

05:38

Well how's that work well we have fifty thousand bucks

05:41

coming to us We think and hope and pray two

05:44

years from now We then divided by one plus point

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zero three plus the risk premium of point one seven

05:52

squared or to the second power Why Because it's two

05:56

years of compounding away not one Remember I kind of

05:58

mumbled that one year to the first power thing was

06:01

clever on Alright that's Fifty grand over the quantity One

06:05

point two square or fifty grand over one point four

06:08

four or carrying a present discounted value of fifty k

06:12

divided by that one point four four which is a

06:14

little under thirty five grand Well if we carry this

06:17

forward a year and there's even more risk for the

06:19

fur five hundred thousand bucks we expect in three years

06:23

Well then we get something like a risk premium of

06:25

say twenty two percent tacked onto the safe rate of

06:28

three percent or twenty five percent total And we discounted

06:32

back three years or cubed if it looks like this

06:36

Five hundred thousand dollars divided by the quantity one plus

06:39

point oh three plus point two two to the third

06:43

power Or that's five hundred thousand dollars over one point

06:47

two five cubes Which is almost to telling us that

06:51

the present value of that highly suspect five hundred k

06:55

in profits supposedly coming in from spice in ator was

06:59

about five hundred thousand over too or just over two

07:03

hundred fifty grand in present value today Got it Well

07:07

same holds true for that million dollar year and calculate

07:10

the discounted cash value of that million bucks four years

07:14

from now you follow the same pattern and add in

07:16

the million bucks divided by the quantity one Plus you

07:19

know all the other crap in there Yeah So if

07:22

we're getting the total discounted cash flow valuation of the

07:25

company we just add everything up including a sale of

07:28

the company at the end Like if we sold it

07:31

for two and million dollars six years from now we

07:33

discount that back with some you know premiums and someone

07:36

loaded in so that ten million's not a sure thing

07:39

at all We have to assume our guests or dark

07:41

board with blindfolds on the value of the company overall

07:44

will hold for five years from now And yeah that's

07:48

How This kind of cash flow works at least the

07:50

one point overs you're learning here So just be careful

07:52

when you throw that dart You don't want to force

07:54

your business partners to rock and ipad shit no matter 00:07:57.755 --> [endTime] how much that looked cool Oh

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