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

Every investor should have a basic grasp of the discounted cash flow (DCF) technique. Here, Tim Bennett explains what DCF is and explains how you can use it to value a company.

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Closed Caption:

yeah
yeah
yeah
welcome to this video on discounted cash
flow
now this fits into my valuing companies
series
so those people have not seen the
introduction video three ways to value a
company that could be useful background
today I'm going to take on the third
technique all right just to remind you
if you are looking at your property for
example you could go to bottom up and
try and value it based on the cost of
bricks and mortar
all right that's quite an S at approach
when applied to a company that's not
today's video you could look at similar
houses in the street
fine work out of yours is worth
something similar I'll be a multiple
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 for a
point of view of how much money it will
generate in the future
some people value properties by saying
let's just look at the rental income we
can squeeze out this thing in the future
bring that together and come up with a
number well back in companies speak is
called discounted cash flow
all right and that's why we're going to
focus on here so with no more ado let's
imagine very simple scenario little bit
of math coming up
let's imagine that we have a company
with a five-year life
they also straight away that's
artificial or 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
ok so how do you go about it you would
say right I reckon I can forecast the
cash flows for this company of the next
five years
all right imagine i've managed to do
that so I managed to forecasting sales
costs to get to some kind of Prophet
turn into cash flow and uncomfortable
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 a hundred million a hundred
million
this is always sterling our key right in
the pound sign they're just get annoying
after awhile hundred million and a
hundred million
all right now it is a very simple
example introductory video like always
two balls later if there is demand so
far so what you might say well that's
easy to quickly did you write on the
board
the company is going to generate
hundred million thanks five years it's
only in the last five years so it's
worth to our five hundred million
not so fast all right go straight away
you got a problem which is if you got
your forecast 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 is no because inflation
erodes the value of money over time
now there's not a math video and I cover
sort of discounting somewhere else i
mentioned and but what I'm about to say
is you can just add up these under
millions and say well the company is
worth 500 million that's the value of
the income generated because you need to
do something all discounted hence the
expression
DCF discounted cash flow so i'll make
another assumption here and you might be
saying how can you make all these
assumptions well in practice this is
exactly what people need to do you apply
this technique
so is my next assumption I'm gonna say
that interest rates in the next five
years will be ten percent now if you
take an interest rate of ten percent
what you're gonna be doing is saying
well based on that one hundred million
received in a year's time is worth a
little bit more of a hundred million
received in two years time when you were
a little bit more than hundred we
believe in three years time and so on
and so forth
and the reason for that is that
basically if you've got a hundred
million in a year's time you could be
investing it was it this way to earn
interest ten percent so it's worth more
to you than a hundred million received
in 45 years time because i can't be
invested now to learn anything
alright so money has a time value the
sooner you get it the more it's worth
basically so cut to the chase what you
need to do is reduce these future
hundred millions back to the equivalent
of today's money call discounting ok
and those people take he's out there who
want to know the little formula that you
use to do this and all sort of cut in
and give you the numbers but the formula
you use says what you should do is take
each
flow and apply a little formula that
says basically you divide it by 1 plus r
to the n that is in the math video but r
is the interest rate and the number of
periods so i would divide the first
years cash flow students received 12
months time by 1 / 1 point 1 then the
second one divided by 1 point 1 squared
. 1 cubed and so on
ok if you do that this is just an
introductory video remember to show the
principles if you like if you do that
you find you need to reduce rounding
slightly the first years cash flow a
little bit hundred million years time is
worth quite as much as it's only a few
hundred million pounds now if interest
rates temp sensor could read it now
you've invested
I know that m % ok then introduced the
second-years cash flow around it
slightly by . 831 where these numbers
come from
that's basically one over 1.1 squared
Matthews out there
ok the next year's cash flow again not
gonna do more than two decimal places
you x 2.75 and actually is cash flow by
. 68 an x 1 x naught . 62 now the effect
of this is as follows
what you're actually saying is that a
hundred million received one year from
now isn't worth as much of a hundred
million you rather have it now
it's actually only worth roughly 90
applying this kind of principles equally
a hundred million received in two years
time isn't as valuable a hundred million
out of interest rate stem sent it is in
theory of interest rates at zero but
rarely our interest rate 0 there close
to help but they're not quite 0 instead
of ten percent is quite high
explain where I got that from the moment
it would reduce the second is calculated
more like 83 is simply multiplying these
out
75-68 and 62 all the millions all in
sterling
all right and that means adding them all
together
the way that I keep raising net present
value of those five years cash flows in
today's money if interest rates a ten
percent is roughly three hundred and
seventy a million not 500 million you
what you what you get you just add them
all together
ok and the higher interest rates are the
lower the value of those cash flows and
the lower the value of the firm overall
ok where this is going is that you know
if i was using this technique to value a
company that could generate a hundred
million in five years consecutively that
interface ten percent i get 2 3 in 78
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 3 pounds
78
ok now very simple introduction some of
you will be out there screaming into the
ether we pretend they're at the other
you've made lots of assumptions here
there are things missing
okay so I'm gonna finish this video i'm
very happy to carry the story on this
demand for everyone to finish this video
by saying you know what could possibly
go wrong
okay what happened i considered where
the ambiguities if you like
okay first of all do companies stopped
after five years
not usually they get going and 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 adding all the end of terminal
value of B be saying you know what
after five years there's no point in
forecasting individual cash flows it's
bad enough for casting for five years
you know i'm not going to carry on
forecasting something in my eye - 15
years time
I'm just going to say I reckon the
company will generate a certain lump of
money for the root for its remaining
life and I discount that back in one go
its cool the terminal value and that's
all I'm gonna say about in this video
so underneath that out here its part
number one problem - how good our
forecasts in the first place
good question forecasting cash flows is
hard
all right
and if you make a mistake in the early
years it radically changes the value
come out with down here
problem number two I didn't say DCF was
easy or . accurate
problem number three screaming at you I
default is well enough
did you can talk some sense why not 50
120 and the answer that is people to
scratch their heads long and hard about
where to get him several the 10-percent
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
if you can put your money into a bank
account that paid a decent interest rate
you want even more for investing in a
risky company that pushes the right up
potentially as well
ok liquidity how easy is it going to be
to get these cash flows out the company
all these things affect ten percent and
there are various models with your won't
go into today
one of them school the capital asset
pricing model investors used 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 well what
you have exactly what you have is a
technique that looks quite scientific
she done in full and gives you a number
of good friends and a million
ok but I leaving companies is an easy
there's no foolproof scientific method
it requires you to make quite a few
assumptions that requires you to do
forecasting required to come up with the
right interest rate or require you to
have it
add everything up correctly but it is
nonetheless recognized as one of the
sort of front-running techniques use
value our companies or even individual
shares
ok 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
yeah