Every student of investing is taught the core principle of discounted cash flows. This business principle is also used with intrinsic value. Application of discounted cash flows assists value investors with determining intrinsic value. Academia, major investment brokerages and the majority of investment websites place unquestionable belief in this single formula to equate value for a security. The problem is that all of them forget or ignore the underlying requirements to use and then, rely on the outcome of the formula’s solution. In effect, with intrinsic value and the application of discounted cash flows, there is a very narrow set of highly defined parameters whereby this tool is applicable and useful. Used outside of this framework, the result’s reliability quickly drops to nearly zero, similar to how the bell curve moves from the most likely outcome in the center to extremes on either side.<\/span><\/p>\n Look at this bell curve. Application of discounted cash flows can produce an excellent solution contingent on NO<\/strong> or limited deviation from the norm (the highest point in the curve). This article starts out by identifying the highly restrictive requirements to apply discounted cash flows. There are at most 20% of all marketable securities where this formula succeeds in determining intrinsic value. Secondly, the formula is explained to the investor and why it is so important to apply it properly. There are several terms and values the user must include in the formula; this section explains them in layman’s words.<\/span><\/p>\n The third section below goes into the corporate financial matrix to explain how to determine cash flows. Furthermore, cash flows are just not the past year or years; it is really about future cash flows. How do you equate value from an unknown variable well into the future?<\/span><\/p>\n The overall goal of value investing is to buy a security at less than intrinsic value, commonly referred to as creating a margin of safety; then waiting for the market price to recover to a reasonable high and then selling that security. The depiction here illustrates this concept well.<\/span><\/p>\n The most popular method to determine intrinsic value is the discounted cash flows method. Experts espouse this tool because it is advocated in the book Security Analysis<\/em><\/strong><\/span> written by Benjamin Graham and David Dodd, the fathers of value investing. However, most so called experts didn’t read the entire book. Graham and Dodd only used this method under certain conditions. The same conditions as explained in the first section below. They strongly encouraged calculating intrinsic value from the assets valuation perspective (balance sheet basis) and not as a function of earnings plus cash adjustments (cash flow). What so called intelligent professionals fail to recognize and embrace is that the discounted cash flows method is only used under a limited set of parameters. The discounted cash flows method<\/span><\/strong><\/a> is taught in every business major and is most commonly used with the finance (banking) degree. The bleed over into investing propelled this formula to the forefront of investment lingo because it appears to resolve several complex needs. The reality is utterly different. The following section goes into detail about this particular finance algorithm and the restrictive set of conditions with which to apply the formula.<\/span><\/p>\n In the perfect world, there is no inflation, there is no cost of money and a particular investment would return the exact same amount of interest year after year without risk; without failure to continue; with constant demand by the market for the product and no deviations from performance. It is simply flawless. Here, one can easily determine the return on one’s investment; it is simply the cumulative sum of all future earnings in the form of cash less one’s investment.<\/span><\/p>\n As an example, a farmer is selling you a goose, yep, the one that lays a golden egg every day and the goose never dies. The farmer is just tired of watching the goose. You agree to buy it for $10,000. The market never changes, the egg weighs exactly one ounce and the goose produces one egg a day forever. Gold prices never change, gold is $10 an ounce. Thus, after one year, you earn exactly $3,650. Each year after, you earn another $3,650 and this goes on forever. As stated above, the conditions are perfect:<\/span><\/p>\n Well, this investment seems easy to calculate. After 3 years, you have earned $10,950 and you’ve gotten your original investment back plus some. Now, the investment will just continue to provide you with $10 a day for the rest of your life, your children and grandchildren’s lives. This is just too good to be true.<\/span><\/p>\n Notice how unrealistic this really is. First off there is inflation! Because inflation is the number one issue with lending money, an investor has to take this into consideration. Buying a security is very similar to lending money. Financial resources leave your pocket and in return you get a piece of paper with a promise to pay or some type of rights to control the outcome. This desired payment whether as interest on a bond or as a dividend for stock is the return on the investment you crave. This so called return will not happen immediately. You will receive these incremental payments over time. Thus, inflation decreases the value of each incremental payment. Assuming each incremental payment is equal and inflation is nominal, the payment received 30 years from now will be almost half in comparison to the first payment you will receive. A simple annual inflationary rate of 2% means that the payment received 30 years from now is only worth 55 cents on the dollar. If the inflationary rate is 4%, the value of that future payment drops to 31 cents on the dollar.<\/span><\/p>\n This is what the discounted cash flows is referring to when talking about making an investment. Again, all other parameters are perfect; its just inflation you need to consider.<\/span><\/p>\n This too is unrealistic. Other factors come into play. Now the formula starts to get more difficult to calculate. The most obvious is that the core formula assumes the cash payments are equal. The market doesn’t work that way. With bond payments, yes; with dividends, the answer is no. Dividends are constantly changing. Value investors only consider high quality, top 2,000 companies to invest with; these companies have continuously improving dividend payments. With most, dividend payments almost double every ten years. Now, there is a new dynamic brought into the formula. Not only do we have to discount the cash flows for inflation, but the cash flows are not even throughout the life of the investment.<\/span><\/p>\n For the discounted cash flows method of determining value to work well, it assumes a highly defined set of restrictions including:<\/span><\/p>\n There are only so many publicly traded securities that meet this criteria. Immediately, any reasonable investor would automatically eliminate penny and small-cap investments. These types of investments are tied to young growing companies. It is highly unlikely that the discount rate will remain stable even in the short-term forecast (next three years). Any new product or service this company provides is unpredictable related to market acceptance and more importantly, competition. It is nearly impossible to state with a high degree of confidence that there will be future net positive cash inflows for this company. The simple truth of the investment is that companies that fall within this market capitalization spectrum have a much higher degree of default both in the form of bankruptcy and almost certainly at times, insolvency.<\/span><\/p>\n Middle capitalization companies are in a much better position than penny and small caps. However, they lack the one key element with exercising the discounted cash flows formula – stability of earnings. Only high quality, top 2,000 companies can demonstrate a long history of continuous positive earnings. It is from earnings that an investor begins the necessary adjustments to determine cash flows. This is explained further in the third section below. The key for the investor is that the discounted cash flows method to determine value is only effective with top notch corporations. The required attributes include:<\/span><\/p>\n Even out the top 2,000 companies, a recognizable portion are unable to demonstrate these three required attributes to apply the discounted cash flows tool. A perfect example is Tesla. Tesla lacks history of earnings and secondly; Tesla has competition and therefore it is difficult to have a high level of confidence that there will be demand by consumers for its vehicles six to seven years from now. To further validate this, General Motors recently announced its intention to develop and sell electric autos starting in the mid part of this decade. This will eat into Tesla’s market share of the electric car market. The novelty of owning a Tesla has worn off. <\/span><\/p>\n The above attributes can be summed up as follows:<\/span><\/p>\n For those of you that are savvy investors, the attributes mirror those attributes used with the dividend yield theory. The difference is that value investors are not buying solely for dividends, they are buying low to ultimately sell high in the near future, generally within two years. The dividend is just an additional benefit. The real value is the growth in the market price for the respective security.<\/span><\/p>\n If the attributes exist to apply this formula, then the investor needs to understand the formula’s two most important elements.<\/span><\/p>\n The discounted cash flows formula is straightforward. How much is a certain set amount paid in a given period in the future worth today? If the payments are made as a stream over several periods of time, the net result is the cumulative sum of each individual period.<\/span><\/p>\n All the periodic payment periods are spaced equally apart, like a month, a quarter or a year. Each successive period has the discounted rate raised by the power of that period. Therefore, the formula is:<\/span><\/p>\n Discounted Cash Flow Value =\u00a0 \u00a0Cash Flow Period 1\u00a0 \u00a0 \u00a0<\/span> \u00a0 \u00a0 PLUS\u00a0 \u00a0 \u00a0 \u00a0Cash Flow Period 2\u00a0 \u00a0<\/span> \u00a0 \u00a0 PLUS\u00a0 \u00a0 \u00a0Cash Flow Period 3\u00a0<\/span>\u00a0 \u00a0PLUS\u00a0 \u00a0 \u00a0…<\/span> The impact of time reduces the value of a future payment significantly. Look at the following table for a payment of $100 per year over 15 years given four different discount rates.<\/span><\/p>\n Period<\/span>\u00a0 \u00a0\u00a0 2%\u00a0<\/span>\u00a0 \u00a0 \u00a0 \u00a0 3%\u00a0<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a05%\u00a0<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a08%<\/span><\/strong>\u00a0<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0<\/span> If you study the table and look at the graph, there are several important aspects of the discount rate that an investor must understand in order to give the discount rate its proper respect. First off, as the discount rate increases, the end results decreases. Furthermore, the longer the time frame involved, the lower the value each extending period out produces for the investment. In effect, what this table and graph illustrates is that a $100 per year cash inflow for 15 years will return $1,500. However, depending on the discount rate involved, the value of that $1,500 is going to be only effectively worth so much today.\u00a0<\/span><\/p>\n To illustrate, assume a company proposes to sell its bond to you for exactly $1,000 of value. In exchange, you will receive exactly $100 per year for 15 years. There is no terminal payment; just a flat $1,500 in equal installments. Remember, this bond must meet all three ot the criteria to qualify to use the discounted cash flows method when evaluating an investment. First, it must be a secure investment (assume its a Walmart Bond). Secondly, the company must have a history of positive earnings; Walmart qualifies for this particular required attribute. And finally, the company provides a highly desired product mix; Walmart fits this attribute too. Thus, this investment offer meets all the required criteria as a solid investment.<\/span><\/p>\n Now the question is – What is my discount rate? Looking at the table above, if you use 5% as the discount rate, it means you get $1,040 of value over the course of 15 years. Since you are paying $1,000 for the investment, you are technically increasing your wealth by $40 over this 15 year time period. <\/span><\/p>\n As an alternative, the bank is offering to pay you 4% interest per year on a $1,000 Certificate of Deposit. This means that over 15 years, you will receive $1,400 ($1,000 of principal and $400 of interest). Whereas with the bond, Walmart is willing to give you $1,500 over the same time period. Thus, the discount rate with the Walmart bond is slightly more than 5.5%.\u00a0<\/span><\/p>\n The key for the investor is that the discount rate is your personal desire for a rate of return on an investment. If your personal rate is 6% return, then the bond isn’t worth $1,000 up front; you are forced to offer a lower value for the rights to receive $100 per year for the next 15 years. It turns out, at 6%, you are willing to pay $971.22 for the rights to the $100 annual payments. This doesn’t mean the seller, in this case Walmart, will accept that; what it means is that the two parties are close. Walmart is willing to pay 5.5% interest and the buyer wants 6% interest. If another investor is willing to accept a 5.5% return on their investment, then Walmart will sell to the other party. This is supply and demand.\u00a0<\/span><\/p>\n This is the exact same relationship with any security in the market. How much are you, the buyer, willing to pay to own a certain set of rights? The most coveted right is a financial reward for your investment. With bonds, investors want interest and of course the original principal back. With stocks, investors want both dividends and an increase in value of the market price for that stock. The right to vote your shares have little to no value for the common stock trader.<\/span><\/p>\n In order for the market price to increase, other buyers in the market must be willing to pay more than you paid for the same stock certificate. There is only one way this is going to happen. The company must be growing which in turn creates desire with other investors. The industry is stable and the economy is not in a recession. Growth is defined as continuously increasing earnings.\u00a0<\/span><\/p>\n Don’t forget, time with the discounted cash flows formula works against value. The further out the cash inflows are received, the lower the overall worth of that respective inflow. Go back to the table, look at the 8% column and go out 15 years. With a discount rate of 8%, the $100 payment is only worth about 32 cents on the dollar. Time is of the essence with the discounted cash flows formula.<\/span><\/p>\n For value investors, what they seek to do is to set a low buy price for a particular security. They also want some assurance the particular security’s market price will increase in a reasonable period of time in order to sell this security at a higher price and earn gains. The discounted cash flows formula is used with certain types of companies because it can effectively provide a comfortable buy price if the discount rate is tolerable by investors. The key is that the value investor’s discount rate must be higher than the market’s tolerated discount rate. This allows the value investor to buy the security at a lower price and then sell this security in a market that believes a lower discount rate is reasonable and acceptable. This part is explained in more detail in the final section below. For now, the investor wants to know how do you determine cash inflows? What exactly are cash inflows<\/span>?<\/p>\n In the last section, emphasis was placed on both the discount rate and the period of the investment. But the formula has another essential element necessary to equate a final value – cash inflows. If you asked 20 professionals to define cash flows for the discounted cash flows formula, you will get 24 to 30 different responses. There is no single correct answer; there are good answers and poor responses.<\/span><\/p>\n At one end of the spectrum of responses, an investor will tell you that the only cash inflow that counts with the formula is the actual cash the investor receives, i.e. dividends and the proceeds from the final sale of the security. Is this the appropriate outcome for cash flows in the formula?<\/span><\/p>\n At the other end of the spectrum, a professional investor will state that cash inflows equals earnings net of taxes, plus depreciation\/amortization and any other non-cash adjustments. This is commonly referred to as cash flow from operations. The thinking here is that this cash flow covers both reward to the shareholders and any remaining cash is used to maintain or expand the company’s operations which ultimately benefit shareholders as growth results in greater dividends in the future.<\/span><\/p>\n If you look at how profits are typically used, they are used for four different purposes:<\/span><\/p>\n Other investors will take a more conservative approach than the extreme position of cash flow from operations and state that cash inflows equals cash flow from operations less the amount necessary to keep the company in the same economic position as it started at the beginning of the year. In effect, it equals cash flow from operations less investment in property, plant and equipment. This particular point along the cash inflows spectrum is referred to as ‘Free Cash Flow’.<\/span><\/p>\n The best answer the author has researched and agrees with is that cash flows equals actual value a shareholder will receive whether immediately in the form of dividends AND\/OR via growth of the company in the future. The key is that growth is different for each industry. Some industries are expanding at phenomenal rates (think of geriatric care, home health and mining) and others are contracting, i.e. in decline (coal, paper information such as periodicals, newspapers etc.). Thus, any retention of profits to fund expansion has a different return on that investment depending on the industry’s position in the economy. Invariably, any dollar retained is not going to grow at a rate a dollar in the hands of the investor can earn via reinvestment. In effect, the discount rate for retained dollars must be higher than the discount rate an investor would use with actual cash received in the form of dividends or interest. The end result is a highly complex formula to derive a current value for cash inflows.<\/span><\/p>\n Fortunately, the very restrictive nature of the formula’s requirements eliminate industries in decline; remember, one of the required attributes to apply the discounted cash flows formula is a strong and desirable services\/product mix for the investment under scrutiny. For the investor, growth from the respective retained earnings will never match the return on reinvestment from immediate cash returned to the investor (dividends and interest); thus, utilize a slightly higher discount rate to compensate for this dampening impact growth has with retained dollars.<\/span><\/p>\n Thus, a good answer to determine cash inflows is as follows.<\/span><\/p>\n Cash inflows equals net earnings adjusted for:<\/span><\/p>\n This formula almost mimics free cash flow as commonly defined by academia. It is different in that there is an additional deduction to fund growth. This additional dampening value reduces cash inflows with the formula and ultimately the net present value of those inflows. In most cases, this dampening value approximates 20% of average depreciation from the most recent three years.<\/span><\/p>\n The key to making this work is to use the average earnings adjusted for the respective four items above from the last seven years. If the company is growing, there will be an average growth determinant from this history. This growth rate is used for determining future inflows over the next five years. In addition, to keep the formula straight forward, the sixth iteration is the projected cash inflow for the sixth year times a factor of 20 discounted back to today’s dollars. This way, the investor doesn’t have to project out for another 20 years. The core intrinsic value outcome using the discounted cash flows method has marginal contribution beyond 25 years, go back to the table above, the results are dropping by more than 3% per year after 15 years. Thus, there is not much contribution from a value in the 26th year utilizing the discounted cash flows formula.<\/span><\/p>\n![\"Discounted](\"https:\/\/businessecon.org\/wp-content\/uploads\/Discounted-Cash-Flow-1.jpg\")
<\/span><\/a>\u201cMoney makes money. And the money that money makes, makes money.\u201d<\/span>\u2013 <\/span><\/strong>Benjamin Franklin<\/span><\/p>\n<\/span><\/p>\nThe final section puts it together when determining intrinsic value. Unlike what others state, intrinsic value is not a definitive value; it is a range. The job of the value investor is to narrow that range to a set of values that are reasonable and effective with generating gains with the value investor’s mindset of ‘buy low, sell high’.<\/span><\/p>\nDiscounted Cash Flows – Highly Defined Set of Parameters<\/strong><\/span><\/h2>\n
<\/a><\/p>\n\n
\n
\n
\n
Discounted Cash Flows – Formula Analysis<\/span><\/strong><\/h2>\n
\n.\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 (1 + Discount Rate)\u00b9 <\/span>Power of One<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0(1 + Discount Rate)\u00b2 Power of Two<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0(1 + Discount Rate)\u00b3 Power of Three\u00a0 \u00a0<\/span> \u00a0\u00a0<\/span><\/span><\/p>\n
\n1\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$98.04\u00a0 \u00a0 $97.09\u00a0 \u00a0 \u00a0$95.24\u00a0 \u00a0 \u00a0$92.59<\/span>
\n2\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a096.12\u00a0 \u00a0 \u00a0 94.26\u00a0 \u00a0 \u00a0 \u00a090.70\u00a0 \u00a0 \u00a0 \u00a085.73<\/span>
\n3\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a094.23\u00a0 \u00a0 \u00a0 91.51\u00a0 \u00a0 \u00a0 \u00a086.38\u00a0 \u00a0 \u00a0 \u00a079.38<\/span>
\n4\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a092.38\u00a0 \u00a0 \u00a0 88.85\u00a0 \u00a0 \u00a0 \u00a082.27\u00a0 \u00a0 \u00a0 \u00a073.50<\/span>
\n5\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a090.57\u00a0 \u00a0 \u00a0 86.26\u00a0 \u00a0 \u00a0 \u00a078.35\u00a0 \u00a0 \u00a0 \u00a068.06<\/span>
\n6\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a088.80\u00a0 \u00a0 \u00a0 83.75\u00a0 \u00a0 \u00a0 \u00a074.62\u00a0 \u00a0 \u00a0 \u00a063.02<\/span>
\n7\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a087.06\u00a0 \u00a0 \u00a0 81.31\u00a0 \u00a0 \u00a0 \u00a071.07\u00a0 \u00a0 \u00a0 \u00a058.35<\/span>
\n8\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a085.35\u00a0 \u00a0 \u00a0 78.94\u00a0 \u00a0 \u00a0 \u00a067.68\u00a0 \u00a0 \u00a0 \u00a054.03<\/span>
\n9\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a083.68\u00a0 \u00a0 \u00a0 76.64\u00a0 \u00a0 \u00a0 \u00a064.46\u00a0 \u00a0 \u00a0 \u00a050.02<\/span>
\n10\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a082.03\u00a0 \u00a0 \u00a0 74.41\u00a0 \u00a0 \u00a0 \u00a061.39\u00a0 \u00a0 \u00a0 \u00a046.32<\/span>
\n11\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a080.43\u00a0 \u00a0 \u00a0 72.24\u00a0 \u00a0 \u00a0 \u00a058.47\u00a0 \u00a0 \u00a0 \u00a042.89<\/span>
\n12\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a078.85\u00a0 \u00a0 \u00a0 70.14\u00a0 \u00a0 \u00a0 \u00a055.68\u00a0 \u00a0 \u00a0 \u00a039.71<\/span>
\n13\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a077.30\u00a0 \u00a0 \u00a0 68.10\u00a0 \u00a0 \u00a0 \u00a053.03\u00a0 \u00a0 \u00a0 \u00a036.77<\/span>
\n14\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a075.79\u00a0 \u00a0 \u00a0 66.11\u00a0 \u00a0 \u00a0 \u00a050.51\u00a0 \u00a0 \u00a0 \u00a034.05<\/span>
\n15\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a074.30<\/span>\u00a0 \u00a0 \u00a0 64.19<\/span>\u00a0 \u00a0 \u00a0 \u00a048.10<\/span>\u00a0 \u00a0 \u00a0 \u00a031.52<\/span>
\nTotals\u00a0 \u00a0$1,285\u00a0 \u00a0$1,194\u00a0 \u00a0 \u00a0 $1,040\u00a0 \u00a0 \u00a0 \u00a0$856<\/span><\/p>\n<\/span><\/p>\nDiscounted Cash Flows – Corporate Cash Flows<\/span><\/strong><\/h2>\n
\n
\n
\n