Discount Cash Flow Valuation

Discount Cash Flow Valuation

By Nicholas Murja

You have been asked to invest in a lemonaide stand business. The offer is $20,000 for 50% equity.

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How will you determine if 50% of the business is worth $20,000?​

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​The Investment

Revenue

- Operating Expenses

- Capital Expenditures

= Free Cash Flow

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Free Cash Flow is viewed as money available to shareholders​

​One way is to see how much cash would be available to you?

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Last year the business produced $5,000 of FCF, but with the $20,000 investment we predict the FCF would increase to $30,000. If you took your half of the free cash flow, you'd be $5,000 short of your investment in just year one.

Year 1 Projection

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​	​Year 0	​Year 1
​Revenue	​$10,000	$60,000​
Expenses​	​$5,000	​$30,000
Free Cashflow	​$5,000	​$30,000

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But you aren't going to leave in 1 year. What's gong to be the value in 10-years?

If you stay involved in the business you’ll be entitled to the future profits as well. For simplicity, let’s say that the business stays consistent without any growth for 10 years. This would bring the 10yr return to $150,000. Divide that by the two shareholders and you are entitled to $75,000! That's a 275% return in 10 years!​

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But is $150,000 in 10-Years worth the same as getting $150,000 now?

ROI = Current Value of Investment - Cost of Investment / Cost of Investment

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The problem is that $75,000 in 10 years is not worth $75,000 today. Think about it…if someone offered you $75,000 today or in 10-years which would you want? Of course today! Why? First, you can use that money to generate a return each year for 10 years. Second, there is ALWAYS the risk that you won't get the money you are promised.

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So how do we find the present value of an amount in the future?

We use the Present Value Formula!

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Discounting Future Values

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PV is useful to determine how much money you need to invest now, in order to have $100,000 in 10-years with a 10% growth rate.

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Present Value Formual​a

​Here is the math:

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​​PV= Future Value (1 / (1+ interest rate) ^ number of years

PV = 100,000 / (1+.10) ^ 10

100,000 / 2.594

38,554

Open Ended

Using the link below, Find the present value of $1,000, in 5 years at 7%.

https://www.calculator.net/present-value-calculator.html

Projecting Lemonade Growth

To apply this to the lemonade stand we need a growth rate. For simplicity, because we are trying to figure out DCF, let’s say we expect the stand to grow at a rate of 20% for 5 years and 10% for another 5. 

The model shows us that the investment will generate $399,608 of

FCF over the 10 years.​ But what is that worth today?

To determine the answer, we simply discount to the present day using the PV formula.

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But, we need a discount rate. If we had taken the $20,000 investment and put it in the stock market, I’m confident we could earn 10% a year. Therefore we will discount it by 10%. This discount rate is also called the “cost of capital.”

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Discounting

The Math:​

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​PV = 399,608 / (1+.10) ^ 10

399,608 / 2.594

$154,050

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​This means the business is worth $154,050 today!

​Offer

$20,000 for 50% = $40,000 Valuation​

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​DCF Model

$77,025 for 50% = $154,050 Intrinsic Value​

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This means you are paying $20,000 for something worth $77,025! That's a 74% discount!

How is this helpful?

The value of the business has to be split between the two shareholders. That means the value to the investor would be $77,025.

$154,050 / 2

​Analyzing the Information

​Put simply, you're paying .26 cents for $1.​

Real World Example

Discount

Cash-Flow

Valuation (DCF)​

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Use the link below to do your own evaluation:​​

Https://docs.google.com/spreadsheets/d/12a98Vg98GjeQ_aT-WMVOqoY8NY7Nt_K2tmn2cnIQovs/copy

The share price and ticker are easily found in the summary tab for Apple on Yahoo Finance. The number of shares outstanding are located in the Statistics tab under Share Statistics.

Share Price & Shares Outstanding

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Open Ended

Use the link below, and the statistics tab to find out how many shares outstanding does MSFT have?

https://finance.yahoo.com/quote/MSFT?p=MSFT&.tsrc=fin-srch

Still in the "Statistics" tab, look under “Income Statement” and “Balance Sheet” to find the revenue and net income. Net income is labeled “net income Avi to Common (ttm).” Free Cash Flow is labeled levered Free Cash Flow (ttm).

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Open Ended

Use the link below, and the statistics tab to find out the Revenue, Net Income, and Free Cash Flow for Nike.

https://finance.yahoo.com/quote/NKE?p=NKE&.tsrc=fin-srch

The key assumptions determine the rate of growth for the first first years, the rate of growth beyond five years, and the rate at which free cash flows are discounted back to present day. Growth Rate for next 5 Years can be found under the Analysis tab of the Yahoo Finance Apple Profile under “Growth Estimates.” The terminal growth rate should be a low number usually comparable to inflation (3 or 4%)

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Open Ended

Use the link below, and the analysis tab to find out the expected 5-Yr Growth percentage for Costco

https://finance.yahoo.com/quote/COST/analysis?p=COST

Cost of capital refers to the minimum rate of return needed from an investment to make it worthwhile.

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The discount rate is the rate used to discount the future cash flows from an investment to the present value to determine if an investment will be profitable.

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To keep this number simple we will use a range between 10-12%.The lower the discount rate, the higher the intrinsic value.

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Some companies are worth paying more than others. If you believe the company is worth paying a premium because they are a top company in the field use the 10%. If the company does not deserve a premium, use 11% or 12%.

​Discount Rate

Poll

What do you think an approriate discount rate would be for Disney?

• 10%

• 11%

• 12%

​Revenue Projections

With the user inputs, the spreadsheet projects future revenue and free cash flow. In the chart below, year zero uses the user inputs as a starting point and to calculate the Net and Cash Flow Margins. Revenue for Year 1 is calculated using the Growth Rate for next five years (14.85%). Revenue for Years 6, 7, and the terminal value use the Terminal Growth Rate of 3%. 

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​Net Income Projections

Net income is projected using Year 0 Net Income and the net margin which is simply the percentage of revenue left over for net income (26.6%). Cash flow projections work exactly the same. The Cash Flow Margin is the percentage of Cash Flow left over from revenue (21.2%).

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Multiple Choice

What is the terminal value?

• The value expected beyond the projected time period

• The value of the first 10 years

Unleveraged Free Cash Flows

Remember when we found the present value of the the sum of FCF for the lemonaide stand? That's what happens here at the bottom. The amount of free cash flow is calculated and then discounted back to the present day​.

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The discounted values are added together for the sum of present value of cash flows.​ This is comparable to the Market Capitalization. It is the value of the ENTIRE business, now we have to split it up amongst the owners.

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Intrinsic Value Per Share

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​To determine a fair share price, the sum of cash flows is divided by the Shares Outstanding which gives an Intrinsic Value per Share of $110.52.

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Is this a fair price? ​

The Intrinsic Value Per Share provides a fair value, so long as our rates are correct. Since they are most likely not, Value Investors determine a margin of safety price which provides room for error. Instead of buying at $110.52, a 20% margin of safety would set the buy price at $88.41. The margin of safety ensures the investment is purchased at a fair price and provides more room for profit. ​

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Open Ended

Now lets put what you've learned to the test. Using the DCF calculator, find the intrinsic value per share for Goog.

Poll

Given the intrinsic value you calculated is Goog a buy?

• Buy now

• Buy at a lower price

• Don't Ever Buy