Every investor should have a basic grasp of the discounted cash flow (DCF) technique. Here, Tim Bennett introduces the concept, and explains how it can be applied to valuing a company.

Welcome to this video on ‘discounted cash flow’. Now, this fits into my “Valuing companies” series, so for those people who have not seen the introductory video, "Three ways to value a company", that could be useful background. Today, I'm going to take on the third technique.

Just to remind you, if you are looking at your property, for example, you could go bottom up and try to value it based on the cost of bricks and mortar. That's called a net asset approach when applied to a company.

That's not today's video. You could look at some of the houses in the street and find 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 the company a bit like a property from 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 that, in companies speak is called ‘discounted cash flow’, and that's what we're going to focus on here.

So, with no more ado, let's imagine a very simple scenario with a little bit of maths coming up. Let's imagine that we have a company with a five-year life, and you'll 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'll need to do more work on in practice.

So, how would you go about it? You would say, "All right. I reckon I can forecast the cash flows for this company over the next five years." Imagine I've managed to do that. So I've managed to forecast sales, costs to get to some kind of profit and turn that into cash flow, and I'm comfortable that I can say, "OK, over the next five years…” (so that's one, two, three, four, five years – very simple example) “the forecast cash flows are £100m, £100m, £100m and £100m.”

Now, it is a very simple example – just an introductory video. I can always do more later if there's demand. “So far, so what”, you might say, "Well, that's easy, Tim. Crikey, you didn't need to write that on the board. The company's going to generate £100m for the next five years. It's only going to last five years, so it's worth £500m.”

Not so fast, because, straight away, you’ve got a problem, which is, if you've got your forecast right, and let's assume you have, is £100m 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 maths video, and I cover discounting somewhere else, which I'll mention at the end, but what I'm about to say is you can't just add up these £100ms and say, "Well, the company is worth £500m. That's the value of the income it generates", because you need to do something: ‘discounting’, hence the expression ‘DCF’ (discounted cash flow).

So, I'm going to 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, who apply this technique.

So, here's my next assumption. I'm going to say that, "Interest rates over the next five years will be 10%." Now, if you take an interest rate of 10%, what you're going to be doing is saying, "Well, based on that, the £100m received in a year's time is worth a little bit more than £100m received in two years' time, which is worth a little bit more than £100m received in three years' time", and so on and so forth.

And the reason for that is basically, if you've got £100m in a year's time, you could be investing it, if you want to say it this way, to earn interest of 10%. So, it's worth more to you than the £100m received in four or five years' time, because that can't be invested now to earn anything. So, money has a time value. The sooner you get it, the more it's worth.

So, to cut to the chase, what you need to do is reduce these future £100ms back to the equivalent of today's money – known as ‘discounting’. And for techies out there, who want to know the little formula that you use to do this, and I'll sort of cut in and give you the numbers, well, the formula you use is to take each cash flow and apply a little formula that says, you divide it by one plus ‘r’ to the ‘n’ (1 + r)ⁿ. Now, this isn't a maths video, but ‘r’ is interest rate, and ‘n’ is number of periods.

So, I'm going to divide the first year's cash flow, assuming it's received in 12 months’ time, by one divided by 1.1. Then the second one and divide it by 1.1 squared, 1.1 cubed, and so on, OK?

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 that you need to reduce, rounding slightly, the first year's cash flow a little bit. Because £100m in a year's time isn't worth quite as much as if someone gave you £100m now if interest rates are 10%, because if you had it now, you can invest it and earn that 10%.

Then you need to reduce the second year's cash flow. I've rounded slightly by 0.83. If you're wondering where these numbers are coming from, that's basically one over 1.1 squared, for the math pros out there. The next year's cash flow, again, not going to do more than two decimal places, you multiply by 0.75. The next year's cash flow by 0.68, and the next one by 0.62.

Now, the effect of this is as follows. What you're effectively saying is, £100m received one year from now isn't worth as much as £100m. You'd rather have it now. It's actually only worth roughly £90m, applying discounted principles.

Equally, £100m received in two years’ time isn't as valuable as £100m now if interest rates are 10%. It is, in theory, if interest rates are zero, but rarely are interest rates zero. They're close now, but they're not quite zero. An interest rate of 10% is quite high, and I'll explain where I've got that from in a moment. It would reduce the second year's cash flow to more like £83m. This is simply multiplying these out. 75, 68, and 62, all in millions, all in sterling. All right?

That means adding them all together – wait for the techie phrase here – the ‘net present value’ of those five years cash flows in today's money, if interest rates are 10%, is roughly £378m, not £500m, which is what you get if you just added them all together.

The higher interest rates are, the lower the value of those cash flows, and the lower the value of the firm overall. Where this is going is if I was using this technique to value a company that could generate £100m for five years consecutively at an interest rate of 10%, I'd get the £378m, and then I'd be saying something like, "Well, there's the value of the company if it issues, say, £100m shares, each one is worth about £3.78."

Very simple reduction. Some of you will be out there screaming into the ether, "But, Tim, you've made lots of assumptions here. There are things missing." So I'm going to finish this video by saying, "What could possibly go wrong? What haven't I considered? Where are the ambiguities?"

First of all, do companies stop after five years? Not usually. They keep going. How would I deal with that in practice? I'm not going to do it here. What I'd 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 me saying, “You know what? After five years, there's no point in forecasting individual cash flows. It's bad enough forecasting for five years. I'm not going to carry on forecasting something that might happen in 15 years’ time. I'm just going to say, “I reckon the company will generate a certain lump of money for its remaining life, and I'll discount that back in one go.'" That's called a terminal value, and that's all I'm going to say about it in this video. So, that's problem number one.

Problem number two: how good are forecasts in the first place? Good question. Forecasting cash flows is hard, and if you make a mistake in the early years, it radically changes the value you come out with down here. I didn't say DCF was easy or pinpoint accurate.

Problem number three: screaming at you, I'd have thought, is, where on earth did you come up with 10%? Why not 5%? Why not zero? Why not 20%? And the answer to that is, "People do scratch their heads long and hard about where to get that 10%."

Well, 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.

OK, liquidity. How easy is it going to be to get these cash flows out of the company? All these things affect that 10% and there are various multiples, which I won't go into today. One of them's called a 'capital asset pricing model' that investors use to come up with a rate that reflects the risk potentially associated with these cash flows from this particular company.

So, there you have it. Well, what do you have exactly? What you have is a technique that looks quite scientific, especially done in full, and gives you a number. Sounds good. £378m.

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. It requires you to come up with the right interest rate. It requires you to add everything up correctly. But it is, nonetheless, recognised as one of the front-running techniques used to value a company or even individual shares.

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.