How to value a company using discounted cash flow (DCF) – MoneyWeek Investment Tutorials

welcome to this video on discounted cash flow now this fits into my valuing companies series so those people have not seen the introductory video three ways to value a company that could be used for background today I'm going to take on the third technique alright just to remind you if you are looking at your property for example you could go bottom up and try and value it based on the cost of bricks and mortar alright that's called an S assets approach when applied to a company that's not today's video you could look at similar houses in the street try and work out if yours is worth something similar that'll be a multiples based approach using company jargon and we're not covering that one here either what we're going to do is look at a company a bit like a property from our point of view of how much money you'll generate in the future some people value properties by saying well let's just look at the rental income we can squeeze out of this thing in the future bring that together and come up with a number well we're in companies speak is called discounted cash flow alright and that's what we're going to focus on here so with no more ado let's imagine very simple scenario little bit of maths coming up let's imagine that we have a company with a five year life they all say straight away that's artificial well the whole of discounted cash flow involves making some quite big assumptions at the end I'll explain which ones you need to do more work on in practice okay so how do you go about it you would say right I reckon I can forecast the cash flows for this company over the next five years all right imagine I've managed to do that so I've managed to forecast you know sales costs to get to some kind of profit turn that into cash flow and I'm comfortable that I can say over the next five years so there's one two three four five years very simple example the forecast cash flows are 100 million 100 million this is all in sterling I won't keep writing the pound sign there just get annoying after a while 100 million and 100 million all right now it is a very simple example just the introductory video I can always do more later if there's demand so far so what you might say well that's easy to crack it in you write out on the board the company's going to generate a hundred in flex five years it's only in the last five years so it's worth tada five hundred million not so fast alright because straight away you've got a problem which is if you've got your forecasts right let's assume you have is a hundred million in five years time worth as much as it is received in one year's time and the answer's no because inflation erodes the value of money over time now this is not a math video and I cover sort of discounting somewhere else which I mentioned the end but what I'm about to say is you can't just add up these hundred millions and say well the company is worth five hundred million that's the value of the income generates because use do something called discounted hence the expression DCF discounted cash flow so I'll make another assumption here you might be saying how can you make all these assumptions well in practice this is exactly what people need to do to apply this technique so is my next assumption I'm going to say that interest rates over the next five years will be ten percent now if you take an interest rate of 10 percent what you're going to be doing is saying well based on that 100 million received in a year's time it's worth a little bit more than under a million received in two years time which is worth a little bit more than hundred million receive in three years time and so on and so forth and the reason for that is that basically if you've got 100 million in a year's time you could be investing it if you want to see it this way to earn interest to ten percent so it's worth more to you than 100 million received in four or five years time because that can't be invested now to earn anything all right so money has a time value the sooner you get it the more it's worth basically so it cuts the chase what you need to do is reduce these future hundred millions back to the equivalent of today's money called discounting okay and for those people techies out there who want to know the little formula that you use to do this and then I'll sort of cut in and give you the numbers but the formula you use says what you should do is take each cash flow and apply a little formula says basically you divide it by 1 plus R to the N as in the math video but R is the interest rate and the number of periods so I'm going to divide the first year's cashflow assuming it's received in 12 months time by 1 divided by 1.1 then the second one divided by 1.1 squared 1.1 cubed and so on okay if you do that and this is just an introductory video remember just to show you the principles if you like if you do that you find you need to reduce rounding slightly the first year's cash flow a little bit because 100 million in a year's time isn't worth quite as much as if someone gave you a hundred million pounds now if interest rates 10% because you shut it now you can invest it another than that 10% okay then you need to reduce the second year's cash flow I've rounded slightly by 0.8 3 you're wondering where these numbers come from that's basically 1 over 1.1 squared the math mows out there okay the next year's cash flow again not going to do more than 2 decimal places you multiply by 0.75 and actually is cash flow by 0.68 and then x1 by noir point 6 2 now the effect of this is as follows what you're effectively saying is that 100 million received one year from now isn't worth as much a hundred million you'd rather have it now it's actually only worth roughly 90 applying this kind of principles equally 100 million received in two years time isn't as valuable 100 million now have interest rates 10% it is in theory if interest rates are zero but rarely are interest rate zero they're close now but they're not quite zero interest rate of 10% is quite high explain where I got that from in a moment but it would reduce the second year's cash flow to more like eighty three is simply multiplying these out 75 68 and 62 all in millions all in sterling all right and that means adding them all together the weight that a key phrase a net present value of those five years cash flows in today's money traitor 10% is roughly 378 million not 500 million which is what you get you just added them all together okay and the higher interest rates are the lower the value of those cash flows and the lower the value of the firm overall okay and where this is going is that you know if I was using this technique to value a company that could generate a hundred million five years consecutively it interest rates 10 percent I get to 378 million and then I'll be saying something like well there's the value of the company if it's issued say a hundred million shares each one is worth about three pound seventy eight okay now very simple introduction some of you will be out there screaming into the ether but Tim they're either you've made lots of some shion's here there are things missing okay so I'm going to finish this video I'm very happy to carry this story on if there's demand for it we'll finish this video by saying you know what could possibly go wrong okay what haven't I considered where are the ambiguities if you like okay first of all do companies stop after five years not usually they keep going okay how would I deal with that in practice I'm not going to do it here what I need to do is plug in what they call a terminal value and then discount that back and add it on the end a terminal value would be being saying general after five years there's no point in forecasting individual cash flows it's bad enough forecasting for five years you know I'm not going to carry on forecasting something might happen in 15 years time so I'm just going to say I reckon the company will generate a certain lump of money for the route for its remaining life and I'll discount that back in one go it's called a terminal value again that's all I'm going to say about it in this video so I've missed that out here that's problem number one from them to how good our forecasts in the first place good question forecasting cash flows is hard alright and if you make a mistake in the early years it radically changes the value you come out with down here that's problem number two I didn't say DCF was easy or pinpoint accurate problem number three screaming at your Ida for is where on earth did you come Tencent why not five why not zero one or twenty and the answer that is people do scratch their heads long and hard about where together at him several the 10% reflects a number of things the riskier you think this business is the higher that number will be the higher the value of other opportunities so if you could put your money into a bank account that paid a decent interest rate you'd want even more for investing in a risky company that pushes the rate up potentially as well okay the quiddity how easy is it going to be to get these cash flows out of the company all these things affect 10% and there are various models which I won't go into today one of them is called a capital asset pricing model investors use to come up with a rate reflects the risk potentially associated with these cash flows from this particular company alright so there you have it or what you have exactly what you have is a technique that looks quite scientific actually done in full and gives you a number as good friend ransom you eight million okay but valuing companies isn't easy there's no foolproof scientific method it requires you to make quite a few assumptions it requires you to do forecasting or require you to come up with right interest rate or requires you to have adding up correctly but it is nonetheless recognized as one of the sort of front running techniques used to value our companies or even individual shares okay so to sum up when you're looking at different ways to value a company it's pretty unusual at some point if you don't think about using discounted cash flow to generate one of the numbers that you need you

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