Discounting Future Cash Flows

If you could choose between receiving $1,000 today or receiving $1,000 one year from now, which would you choose? Most people would prefer to receive the money today. Although the amounts are identical, their values are different because of when the money becomes available. You could deposit the $1,000 you receive today into a savings account and earn interest, or invest it in a business and potentially earn a return. However, you cannot use money that you will not receive until next year. During that time, prices might rise because of inflation, and there is also a risk that the promised money might never arrive. This principle is known as the time value of money. It means that the value of money depends partly on when it is received. The process of converting money expected in the future into its value today is called discounting. So how can we determine what future money is worth today? Suppose a bank offers an annual interest rate of 10%. If you deposit $1,000 today, you will have $1,100 after one year. Under these conditions, receiving $1,100 one year from now is equivalent to having $1,000 today. But what if you expect to receive only $1,000 one year from now? Dividing $1,000 by 1.1 gives approximately $909.09. If you deposit that amount in the bank today at an annual interest rate of 10%, you will have approximately $1,000 after one year. Therefore, the present value of $1,000 received one year from now is approximately $909.09 under these assumptions. The 10% used in this calculation is called the discount rate. It is the rate used to convert future money into its present value. What happens if the payment is even further away? If you invest $1,000 today and earn a 10% annual return with compounding, you will have $1,100 after one year and $1,210 after two years. Therefore, receiving $1,210 two years from now is equivalent to having $1,000 today. To calculate the present value of $1,000 received two years from now, you divide $1,000 by 1.1 twice. The result is approximately $826.45. Although the future payment is still $1,000, its present value is lower than if you were receiving it after just one year. But what does this calculation have to do with investing in stocks? A stock represents partial ownership of a company. When a company grows and earns money, its shareholders may benefit through dividends or an increase in the value of their shares. Investors therefore pay close attention to how much money a company might generate in the future. However, simply adding up all the money a company expects to generate does not tell us what the company is worth today. After all, $10 million generated one year from now is not worth the same amount today as $10 million generated ten years from now. One method used to address this problem is called discounted cash flow analysis, or DCF. This approach estimates the value of a company by forecasting the cash it may generate in the future, converting those amounts into present values, and adding them together. An important part of this method is that it does not simply use a company's revenue or accounting profit. Imagine a company that sells $100 million worth of products. Although its revenue is $100 million, it must still pay for materials, employee salaries, factory operations, and other business expenses. The amount of cash remaining may be much smaller. The company may also need to build new factories or purchase machinery to keep operating and expanding. When evaluating its ability to generate cash for investors and lenders, we must consider the money needed for these investments as well. A commonly used measure is free cash flow, or FCF. It is generally calculated by taking the cash generated from operations and subtracting capital expenditures, such as spending on equipment and facilities. Free cash flow helps investors understand how much cash a company's business generates after accounting for these investments. Now imagine a company that is expected to generate $10 million in free cash flow each year for the next three years. Suppose we use an annual discount rate of 10%. The $10 million expected at the end of the first year has a present value of approximately $9.09 million. The $10 million expected at the end of the second year has a present value of approximately $8.26 million, while the $10 million expected at the end of the third year has a present value of approximately $7.51 million. Adding these amounts gives approximately $24.87 million. Although the company is expected to generate a total of $30 million over the next three years, those future cash flows have a combined present value of approximately $24.87 million when discounted at 10% annually. Of course, this does not represent the company's entire value. If the business continues operating after the third year, it may generate cash for many more years. In practice, discounted cash flow analysis typically involves forecasting cash flows over a specific period and then estimating the value of the business beyond that period. But how do investors choose the discount rate? Earlier, we used a bank interest rate to explain the calculation. In actual company valuations, however, investors do not rely solely on savings account interest rates. Investing in a business usually involves risks that are different from those associated with depositing money in a bank. Imagine an established electric utility that generates relatively stable cash flow and a young technology company that has not yet become profitable. Suppose both companies are expected to generate $10 million in cash five years from now. Would investors necessarily consider those future payments equally valuable? The utility may operate a relatively predictable business, while the technology company could face greater uncertainty. Its products might fail to attract customers, or competitors might develop better alternatives. If everything else is equal, investors may demand a higher expected return for taking on the additional risk. Discount rates are selected by considering these risks and the cost of financing a business. When valuing cash flows available to all providers of capital, analysts often use the weighted average cost of capital, or WACC. This measure considers both the returns required by shareholders and the financing costs associated with debt. The discount rate can have a major effect on a company's estimated value. Consider a payment of $1,000 that will be received ten years from now. At an annual discount rate of 5%, its present value is approximately $613.91. At a discount rate of 10%, its present value falls to approximately $385.54. If the discount rate increases to 15%, the present value drops to approximately $247.18. The future payment remains exactly $1,000 in every case, but its value today changes considerably depending on the discount rate. This is especially important when evaluating growing companies. Unlike established companies that already generate substantial cash flow, rapidly growing businesses may be expected to produce much more cash five or ten years from now than they do today. However, cash flows expected far into the future are particularly sensitive to changes in discount rates. If interest rates rise or a company's business becomes riskier, the discount rate used to value its future cash flows may increase. As a result, the estimated value of a company whose worth depends heavily on distant future growth can decline significantly. Conversely, lower discount rates increase the present value of future cash flows. This helps explain why changing interest rates can influence the stock market, particularly stocks of companies expected to experience substantial future growth. Does this mean that the value calculated through discounted cash flow analysis is automatically the fair price of a stock? Not necessarily. First, the value of a company's operations must be distinguished from the value belonging to its shareholders. When analysts discount free cash flow available to all capital providers, they generally need to account for the company's cash, debt, and certain other items to estimate the value attributable to shareholders. Dividing that equity value by the number of shares outstanding gives an estimated value per share. For example, suppose a company's estimated equity value is $100 million and it has 10 million shares outstanding. Its estimated value per share would be $10. If its stock is trading at $8, the market price is 20% below the estimated value. If it is trading at $12, the market price is higher than the estimated value. However, a stock trading below its calculated value is not necessarily a good investment. Discounted cash flow analysis has several important limitations. The biggest challenge is that no one knows exactly how much cash a company will generate in the future. Its revenue growth, operating expenses, competitive position, and future economic conditions are all uncertain. A company expected to grow by 15% annually over the next decade might actually grow by only 5%. On the other hand, it could grow much faster than expected. There is also no single discount rate that everyone must use. Two investors analyzing the same company may have different views about its risks and the returns they require. As a result, they can reach very different valuations even when using the same basic method. Another concern is that assuming high growth rates will continue far into the future can produce an unrealistically high valuation. This is particularly important for companies that are not yet generating substantial positive cash flow, since much of their estimated value may depend on optimistic expectations about the future. For these reasons, investors often calculate several possible values instead of relying on just one forecast. They might examine an optimistic scenario, a reasonable middle scenario, and a pessimistic scenario. Some investors also prefer to purchase stocks at prices well below their estimated values. This provides a margin of safety in case their assumptions turn out to be incorrect. Of course, the uncertainty surrounding future cash flows does not make discounted cash flow analysis useless. In fact, one of its greatest benefits is that it encourages investors to think carefully about what actually makes a business valuable. How much cash could the company generate in the future? How much will it need to invest to keep operating? Can it maintain its current growth rate for many years? What risks could prevent it from achieving its goals? By considering these questions, investors can develop a deeper understanding of a business rather than simply trying to guess whether its stock price will rise or fall. Ultimately, discounting future cash flows is about recognizing that money received in the future is not worth the same amount as money available today. The value of a stock depends not only on how much money its company earns now, but also on how much cash it may generate in the future, when that cash will be generated, and how likely those expectations are to become reality. Just as $1,000 received ten years from now is not equivalent to having $1,000 today, the $10 million a company might earn a decade from now is not worth $10 million today. Understanding this difference is an important starting point for evaluating businesses and making informed judgments about stock prices.