Discounted Cash Flow: Determining how much a business is worth

The kick-off of year 2000 was a time to celebrate.

The S&P 500 had delivered an average yearly gain of 26% for 5 years straight, and it showed no signs of stopping [1].

Few were celebrating the times more than share holders of Cisco Systems (ticker: CSCO.

They were welcomed into the new year with a 2-for-1 stock split on March 22, the second split in 12 months [2, 3].

A day later, on March 23, The New York Times gave hints at the exciting future that laid ahead [4]:

"While profits for both Microsoft and Cisco continue to surge ahead, investors have in recent months afforded companies such as Cisco and database software firm Oracle Corp. higher price-to-earnings ratios amid optimism the torrid growth of the Internet will help to push those companies' earnings even higher.

On Wednesday, Cisco's market value topped $500 billion, a first for a Silicon Valley company, and analysts have said that Cisco could -- if its growth continues -- become the first company ever to be valued at $1 trillion."

On March 27, Forbes declared [5]:

"Wall Street analysts expect another blowout quarter following the spectacular performance of Standard & Poor's 500 companies in the last three months of 1999."

You didn't need to look much further than Cisco's stock to see the evidence.

It ended the day on March 27 at $80.06 per share, a 304% increase from the year before and a 53.8% gain since the start of the year.

Unfortunately, the hyped-up growth never panned out.

Instead the proceeding year would see the stock decline by 77.4% to $18.13 per share.

In fact, 24 years have passed since then and the share price still hasn't recovered to the March 2000 high.

As I write (March 25, 2024), it sits at $55.74. That's 30.4% below 2000 peak of $80.06.

What happened?

In brief, people paid more for the stock than it was worth.

Warren Buffet openly warned about this in an article published by Fortune on Nov 22, 1999 [6]:

"Bear in mind – this is a critical fact often ignored – that investors as a whole cannot get anything out of their businesses except what the businesses earn.

Sure, you and I can sell each other stocks at higher and higher prices. Let’s say the FORTUNE 500 was just one business and that the people in this room each owned a piece of it. In that case, we could sit here and sell each other pieces at ever-ascending prices. You personally might outsmart the next fellow by buying low and selling high. But no money would leave the game when that happened: You’d simply take out what he put in. Meanwhile, the experience of the group wouldn’t have been affected a whit, because its fate would still be tied to profits.

The absolute most that the owners of a business, in aggregate, can get out of it in the end – between now and Judgment Day – is what that business earns over time."

Despite the decline in its stock price, Cisco was (and is) a good company. It doesn’t have any issue making money.

But, the share price got way ahead of the money the business was making.

Here's the company's Operating Cash Flow (OCF) (the money it generates from its business) and share price from 1999 through 2009:

Data source: Cisco's annual reports (10-K's) from 1999 through 2009.

From 2000 to 2009, the company's business generated a total of $79B in cash.

The average number of shares outstanding was 6.6B.

So, over those 10 years, the business generated $12 of cash per share.

That means: People spent $80 on something that would take 10 years to produce $12 of cash.

The amount of cash Cisco was generating increased through those years and the number of shares even decreased (making each share worth more).

But, even with that, the business just wasn't worth $80 per share.

So, the price gravitated towards a more accurate reflection of what the business was worth.

Side note: If you look for old 10-K’s filed by Cisco with the SEC, sometimes you need to look for form 10-K405 instead of 10-K (for example, in 1999). The reason is that, until 2002, the SEC required 10-K's to be filed as "10-K405" if the "Item 405" box on the cover was checked [7, 8]. That box is used to indicate whether there were any delinquent Form 4 filings (reports related to changes in insider holdings). But, this requirement caused confusion. So, the SEC ended it in 2002. Since then, all 10-K's are filed only as 10-K's.

Valuing a business

“I am convinced that the core idea of value investing – the intrinsic value of a company is the sum of all cash flows between now and eternity discounted at an appropriate rate – will be as close to a law of nature as we will ever get in what is ultimately a non-scientific discipline.”
_{Rob Vinall, in RV Capital’s 2020 Letter to Co-Investors in the Business Owner Fund [9]
Note: Rob Vinall runs RV Capital‘s Business Owner Fund, which, has delivered a compound annual return of 15.6% since 2008 (16 years) [10].}

There're a lot of ways we could value a business.

But, some of the most important involve looking at how much cash it'll generate in the future.

That makes sense, right?

The more cash a business generates, the more valuable it is.

Where things get a little tricky is when we consider that money tomorrow is less valuable to money today.

Why's money less valuable tomorrow than today?

Imagine I offer to give you a dollar. No strings attached.

Now, you get to choose whether I give it to you today, or one year from now.

Which do you choose?

I'd choose today.

Here's why:

• I could die before next year and never get to use the dollar

• The person offering me the dollar could die

• They might change their mind and decide not to give me the dollar

• Someone could steal the dollar from them before they can give it to me

• Inflation will make it so the dollar doesn’t buy as much in a year as it does today

• If I put the dollar in my savings account today, I'll get interest on it

• If I have an urgent need, but not much cash, getting the dollar today means I can use it for the urgent need

So, a dollar today is worth more than a dollar tomorrow. And, a dollar tomorrow is worth more than a dollar next week.

Valuing a business by its cash

Imagine someone offers to sell us their business.

For now, let's pretend the business's future cash flows are 100% guaranteed to happen. Let's pretend we're 100% guaranteed to receive the cash and that it's 100% guaranteed to not lose value due to inflation, etc.

The value of the business would then be:

Value = Cash from year 1
  + Cash from year 2
  + ...
  + Cash from year n

Let's say the business will need to shut down in 5 years because it has a special operating permit that expires in 5 years.

It's expected cash flows are:

How much would you be willing to pay for this business?

Anything over $600 would be a bad deal since it'll only ever make us $600.

Paying less than $600 would be good deal, because we’ll end up getting more money than we paid.

Now, if we consider that money tomorrow is worth less to us than money today, even $600 isn’t a fair deal. The price that separates a good deal from a bad one should actually be lowered based on how much less we value future money.

Before we do that, let's take a look at what other options we have for our money.

Alternative options

Let's say our bank's eager to keep us as clients.

So, they offer us a special deal where we'll get 5% annual interest, for up to 5 years.

If we were to deposit $600 and withdraw the amount the business would've given us each year:

That means we could:

1. Put $600 in the bank,

2. take out the same amount of money the business would've produced, and

3. still have $108 in the bank at the end!

Investing in the business is looking like a pretty bad deal at this point!

In fact, any investment that doesn't offer a better outcome than our bank looks like a bad deal now.

So, what would give us a better outcome?

Evaluating outcomes

We know how much cash the business'll produce each year.

Let's assume we can't control that.

What's left that we can control to improve the outcome of buying the business?

I know you already know where I’m going with this.

It's the price we pay.

So, that leads us to the questions of what price makes buying the business at least as good a deal as leaving our money in the bank?

To figure it out, let's see how much cash we'd have to hold in the bank to end with a balance of $0:

So, there it is.

If we deposit $515.32 at the bank, we'll be able to withdraw the same amounts of cash we'd receive from the business and end with nothing left over.

That means that if we pay $515.32 for the business, it'll produce the same result as keeping our money at the bank.

So, we should definitely be looking to pay less than $515.32 for the business.

Here’s a visualization of what happens with $515.32, whether we keep it in the bank or use it to buy the business:

So, now we know what we'd need to pay for the business to have as good an outcome as the deal from our bank.

But, how did we figure out that $515.32 was the amount that'd make the numbers work?

How to figure out the right price

The good news is that we don't have to guess-and-check.

We can calculate it.

At this point, we know:

1. The amount of cash the business'll generate each year

2. That a dollar is less valuable to us in the future than it is today

3. An alternative option for investing our money

At a high level, we can use this information to figure out the price by:

1. Looking at the cash the business'll generate each year

2. Adjust the amounts so they reflect what they're worth to us today

   1. Consider: The further in the future, the less the generated cash is worth

   2. Consider: Keeping our money at the bank would increase our money by 5% each year

3. Add up the adjusted cash amounts

Let's start by looking at year 1.

That year, the business would give us $100 of cash.

How much money would we need to deposit at the bank to be able to withdraw exactly $100 at the end of year 1?

Withdrawal amount = Deposit amount + Interest
Withdrawal amount = Deposit amount + (Deposit amount × Interest rate)
Withdrawal amount = Deposit amount × (1 + Interest rate)
Withdrawal amount ÷ (1 + Interest rate) = Deposit amount

Deposit amount = Withdrawal amount ÷ (1 + Interest rate)

Deposit amount = $100 ÷ (1 + 0.05)
Deposit amount = $100 ÷ 1.05
Deposit amount = $95.24

We'd need to deposit $95.24. The $95.24 deposited, plus the 5% interest earned on it ($4.76), leaves us with $100 we can withdraw at the end of the year.

Withdrawing the $100 at the end of the year would leave our account with $0. So, we'd need to have deposited additional money to be able to withdraw $110 at the end of year 2.

How much more?

For this one, keep in mind that:

• money deposited at the beginning of year 1

• and withdrawn at the end of year 2

• gets interest in year 1 for the initial amount deposited

• and gets interest in year 2 for the initial amount deposited plus the interest received in year 1

Withdrawal amount in year 2 = Deposit amount
  + Year 1 interest
  + Year 2 interest

Withdrawal amount in year 2 = Deposit amount
  + Deposit amount × Interest rate
  + (Deposit amount + Deposit amount × Interest rate) × Interest rate

Withdrawal amount in year 2 = Deposit amount
  + Deposit amount × Interest rate
  + Deposit amount × Interest rate
  + Deposit amount × Interest rate × Interest rate

Withdrawal amount in year 2 = Deposit amount
  + 2 × Deposit amount × Interest rate
  + Deposit amount × Interest rate^2

Withdrawal amount in year 2 = Deposit amount × (1 + Interest rate + Interest rate + Interest rate × Interest rate)

# Note: Notice the quadratic equation on the right
Withdrawal amount in year 2 = Deposit amount × (1 + 2 × Interest rate + Interest rate^2)
Withdrawal amount in year 2 = Deposit amount × (1 + Interest rate) × (1 + Interest rate)
Withdrawal amount in year 2 = Deposit amount × (1 + Interest rate)^2
Withdrawal amount in year 2 ÷ (1 + Interest rate)^2 = Deposit amount

Deposit amount = Withdrawal amount in year 2 ÷ (1 + Interest rate)^2

Deposit amount = $100 ÷ (1 + 0.05)^2
Deposit amount = $100 ÷ 1.1025
Deposit amount = $90.70

So, a deposit of $90.70 would allow us to withdraw $110 in year 2.

What we have so far is that we'd need to deposit a total of $185.94 (because $95.24 + $90.70 = $185.94) to allow us to withdraw $100 in year 1 and $110 in year 2.

We can generalize our formula for determining the amount we need to deposit as:

Deposit amount = Withdrawal amount in a given year ÷ (1 + Interest rate)^Year

Let's apply this to all 5 years:

That's how we figure out that paying $515.32 for the business would make the outcome equal to keeping our money in the bank.

Of course, if we were to buy the business, we'd want to pay less than that. Otherwise, we might as well just keep our lives simple and leave our money in the bank.

"Discounted Cash Flow" analysis

In finance, the process we just did is called a Discounted Cash Flow analysis (or DCF analysis, for short).

It's named this because we did an analysis that "discounted future cash flows to their present value".

In other words, we calculated how much cash, received at future dates, is worth to us today.

The "official" formula for the value of cash received in the future looks like this:

Present value = Cash flow in a given period ÷ (1 + Discount rate)^Period

The present value of a potential investment overall is:

Present value of the investment =
  Cash flow in year 1 ÷ (1 + Discount rate)^1
  + Cash flow in year 2 ÷ (1 + Discount rate)^2
  + Cash flow in year 3 ÷ (1 + Discount rate)^3
  ...
  + Cash flow in year n ÷ (1 + Discount rate)^n

That is, it's what we get when we add up the present values of all the cash generated in the future.

We can think of this as trying to answer the question:

What price do we have to pay for a business today, so that the cash it generates in the future represents a specific growth rate for our investment?

Applying that to the example we've been using, we'd ask:

What price do we have to pay for the business, so that the $600 it'll generate over the next 5 years represents 5% annual growth of the money paid?

As we now know, the answer is $515.32.

Risk

You might've noticed that in our example we didn't take into account the risk that the business fails or delivers less cash than expected.

Imagine all the small businesses that couldn't produce the expected cash when everything was shut down during COVID.

The owners of those businesses never got the cash they'd planned for when they invested in them. In many cases, the businesses failed and the owners lost everything.

Banks, on the other hand, are backed by FDIC deposit insurance [11]. If a bank fails, depositors might not get the interest they planned for, but they're almost certain to at least get their deposits back.

Since there's more risk to receiving all the cash we expect from a business, we'd want to increase the Discount Rate to account for the increased risk. (Which would decrease the present value.)

All the risk factors we might consider, and how to adjust for them, is a big topic.

So, for now, let's just keep in mind that we should actually require a price significantly lower than $515.32 to be willing to invest in our example business.

Conclusion

When we buy shares of a company, we're buying ownership of the company.

That is, when we buy shares, we become owners of the company.

That ownership comes with rights to the cash it generates in the future.

So, we can kind of think of buying shares as buying rights to cash that'll be generated in the future.

Since we're buying cash that'll be generated in the future, it's not worth as much as having an equal amount of cash today.

The price we're willing to pay for shares needs to take that into consideration.

One way to figure out a reasonable price is by doing a Discounted Cash Flow analysis.

That's because DCF analysis considers:

1. Alternative options for growing our money

2. Our expectations for the amount and timing of cash the business’ll generate in the future

The problem with DCF analysis is that it’s built on assumptions. Like, how much cash a business'll generate in the future.

So even though it's a useful tool, it’s just one factor among many to consider when we’re looking at a potential investment (and when we’re determining how much to pay for it).

I hope you found the explanation clear and the information useful!

Happy hunting!

And now for something completely different

I pretty much live under a rock.

So, I hadn’t heard of David Goggins until a friend recently told me about him.

He's a retired Navy Seal and currently a long-distance athlete, writer, and motivational speaker.

But, he's nothing like the image "motivational speaker" brings to mind for me.

He's intense and talks about the grind. Waking up every day, putting yourself through the pain, and making progress.

It's a very "stop-whining and do what needs to be done" kind of message. It's a "shut up and just f***ing do it" kind of message.

Hard days are inevitable and to achieve a lot of things we might want out of life, we just have to accept the grind. It's for sure not for everyone, but I find his message motivating.

Here's an interview of him. I think it’s worth at least listening to a couple minutes to see if it might be your kind of thing: David Goggins: How to Build Immense Inner Strength

References

Noted references:

1. S&P 500 Historical Annual Returns. Macrotrends. Retrieved 2024-10-26.

2. Cisco Systems 1999 Annual Report. Cisco Systems. Retrieved 2024-10-26.

3. Cisco Systems 2000 Annual Report. Cisco Systems. Retrieved 2024-10-26.

4. Cisco Briefly Tops Microsoft as World´s Most Valuable Firm. The New York Times. March 23, 2000.

5. Wall Street Expects Another Blockbuster Quarter. Forbes. Mar 27, 2000.

6. Mr. Buffett on the stock market. Fortune. Nov 22, 1999.

7. EDGAR Online | Help - Form Type Definitions. EDGAR Online, a division of OTC Markets Group. Accessed 2024-10-25.

8. Form 10-K405. Wikipedia. Accessed 2024-10-25.

9. Rob Vinall. RV Capital’s 2020 Letter to Co-Investors in the Business Owner Fund. RV Capital. Accessed 2024-10-26.

10. Rob Vinall. RV Capital Co-Investor Letter for the first half ended June 30, 2024. RV Capital. Accessed 2024-10-26 via Hedge Fund Alpha.

11. FDIC | Deposit Insurance. Federal Deposit Insurance Corporation. Accessed 2024-10-28.

Additional references:

1. Lyn Alden. Discounted Cash Flow Analysis: Complete Tutorial With Examples. LynAlden.com. Retrieved 2024-10-23.

2. DCF Model Training. Wall Street Prep. Retrieved 2024-10-23.

3. Ep 19 - TECHNICALS Discounted Cash Flows and the WACC. The Breaking Into Finance Podcast. July, 2023.

4. Ep 21 - TECHNICALS DCF Model Walkthrough. The Breaking Into Finance Podcast. July, 2023.

5. Aswath Damodaran. Valuation: Online Class. Damodaran Online. Retrieved 2024-10-23.

6. Knowledge Base: Discounted Cash Flow Analysis (DCF) Tutorials. Breaking Into Wall Street. Retrieved 2024-10-23.

7. Discounted Cash Flow (DCF). CFI Education. Retrieved 2024-10-24.

8. Tim Vipond. Discounted Cash Flow DCF Formula. CFI Education. Retrieved 2024-10-24.

9. WACC. CFI Education. Retrieved 2024-10-24.

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