Learn Fundamental Analysis: Discounted Cash Flow (DCF) Analysis (Part-I)

The Future Cash Flow

At the heart of the Discounted Cash Flow (DCF) model lies the idea of future cash flows. Let’s look at the example to understand it better.

Let’s assume, Ram creates a pizza machine that automatically bakes a pizza in 5 minutes. With this machine, he can earn an annual revenue of Rs. 1,00,000. and the lifespan of the machine is 10 years.

His friend Shyam is very impressed with Ram’s pizza machine and offers to buy this machine from Ram. now, how much do you think Shyam should pay to buy this machine? To find the answer, we need to see how economically useful this machine is going to be for Shyam. Assume, he buys the machine today, over the next 10 years, the machine will earn him Rs.1,00,000 each year. Shyam is going to earn Rs.10,00,000. (1,00,000 X 10) over the next 10 years, after that, the machine will be worthless.

Based on these calculations, the cost of the machine cannot be more than Rs, 10,00,000 because it does not make sense to pay an entity a price that is more than the economic benefit it offers.

Let’s say Ram asks Shyam to pay Rs. X to buy the machine. Shyam can either invest X amount of money in a fixed deposit and earn 10% interest plus it also guarantees the capital amount or invest the X amount of money to buy the machine. Let’s say Shyam decided to buy the machine instead of a fixed deposit. This implies Shyam has foregone an opportunity to earn 10% risk-free interest. This is the “opportunity cost” for buying the machine.

So far to price the pizza machine, we have the following information.

1. Total cash flow from the pizza maker is Rs.10,00,000 over the next 10 years. (The cost of the machine should be less than the total cash flow from the machine)
2. The opportunity cost for buying the pizza is an investment option that earns 10% interest.

Keeping the above points in perspective, let's focus on cash flow. We know that Shyam will earn Rs.1,00,000 every year from the machine for the next 10 years. Think about this, Shyam is looking at the future,

1. How much is Rs.1,00,000 that he receives one year from now worth in today’s term?
2. How much is Rs.1,00,000 that he receives three years from now worth in today’s term?
3. How much is Rs.1,00,000 that he receives six years from now worth in today’s term?

In general, how much is the cash flow of the future worth in today’s terms? The answer to this question lies in the “Time value of money”. In other words, if we can calculate the value of all the future cash flow from that machine in terms of today’s value, then we will be in a better position to price that machine.

Time Value of Money (TMV)

The time value of money is a pivotal concept in finance, with applications in various financial principles. It centers around the idea that the value of money changes over time. This means that the worth of Rs. 100 today isn’t the same as Rs. 100 two years from now. Similarly, the value of Rs. 100 in the future isn’t equivalent to Rs. 100 in the present.

To determine the value of money we possess today at some point in the future, we calculate the “Future Value (FV)” by moving the present money forward in time. Similarly, to evaluate the worth of future money in today’s terms, we compute the “Present Value (PV)” by moving the future money back to the present.

In both scenarios, considering the passage of time, the adjustment for the opportunity cost is crucial. This adjustment is termed “compounding” when calculating the future value of money and “discounting” when assessing the present value of money.

Let’s explore a couple of examples to understand these concepts better:

Example 1: How much is Rs. 50,000 worth in today’s terms after five years, assuming an opportunity cost of 10%?

We need to calculate the Future Value (FV) as we are evaluating the value of money in the future.

FV = Amount * (1 + Opportunity Cost Rate) ^ Number of years

= 50000 * (1 + 10%)⁵

= 80,525.5

This means Rs. 50,000 today would be comparable to Rs. 80,525.5 after 5 years, assuming an opportunity cost of 10%.

Example 2: How much is Rs. 50,000 receivable after 5 years worth in today’s terms, assuming an opportunity cost of 10%?

We need to calculate the Present Value (PV) as we are assessing the present value of future cash receivable.

PV = Amount / (1 + Discount Rate) ^ Number of years

= 50000 / (1 + 10%)⁵

= 31,046.1

This means Rs. 50,000 receivable after 5 years would be comparable to Rs. 31,046.1 in today’s terms, assuming a discount rate of 10%.

The Net Present Value of Cash Flow

Let’s get back to our example of a pizza machine, We know, Shyam is entitled to receive a stream of cash flow in the future i.e. Rs.1,00,000 each year for the next 10 years.

So, how much is the cash flow of the future worth in today’s terms? The cash flow is uniformly spread across time. We need to calculate the present value of each cash flow (receivable in the future) by discounting it with the opportunity cost.

The table below calculates the Present Value (PV) of each cash flow keeping the discount rate of 10%.

The sum of all the present values of the future cash flows is known as the “Net Present Value (NPV)”. In this case, the NPV is Rs.6,14,452. This implies that the value of all the future cash flows from the pizza machine, in terms of today’s value, is Rs.6,14,452. Hence, while purchasing the pizza machine, Shyam must ensure that the price is lower than Rs.6,14,452 and not more. This approximate value represents the cost at which the pizza machine should be priced.

Now think about this, what if we replace the pizza machine with a company? Can we discount all future cash flow that the company earns to evaluate the company stock price? Yes, we can and this is exactly what will we do in the “Discounted Cash Flow” model.

Understanding the importance of NPV in the DCF valuation model, let’s delve into a few other topics that are related to the DCF valuation model.

Next Chapter: Discounted Cash Flow Analysis (Part II)