How to Discount Future Cash Flow

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					An investing concept known a discounted future cash flow is sometimes used to calculate the
“intrinsic value” of a stock, bond, or any other investment. The basic concept behind the idea of
discounting future cash flows is that a dollar in the future is worth less to you than a dollar today.
For example, if someone were to say to you, I will give you 1000 dollars today or I will give you
1000 dollars on this day next year, you would most likely choose 1000 dollars today every time.
You would probably choose 1000 dollars today, even if you are not in immediate need of cash.
Discounting future cash flows attempts to put an exact number on how much less that 1000
dollars a year from now is worth to you. Use the same example, this time imagine the question is
as follows: would you rather have 1000 dollars today or 1200 dollars a year from today? The
percentage change that you are willing to except in order to wait one year for your money is
called the discount rate.
When people discount future cash flows by the discount rate they come up with a number known
as the present value. Assume that your discount rate is 10%. This means that for you, 1000
dollars today would be the same as having 1100 dollars next year, which is an increase of 10%.
Discounting future cash flow would actually reverse the calculation by saying 1100 dollars a
year from today, discounted at 10%, has a present value of 1000 dollars.
This is an extremely important concept to understand! If you understand discounted cash flow
you will know how to value any investment. For another example, assume that you open a
savings account and it pays 2% per year. If you reinvest this interest every year, your money will
compound at a rate of 2% per year. If you discount the money that you earn each year by a 2%
discount rate, the present value of your savings account is one dollar. In other words, if you
demand a 2% return on your investment, then you are buying 1 dollar for the price of 1 dollar.
This is not a great deal. As an investor you would like to be buying 1 dollar for 50 cents.
If your discount rate in the savings account example is greater than 2% than you will actually be
buying 1 dollar for over 1 dollar. You might even be paying 2 dollars today to buy 1 dollar in the
future.
What percentage to use as a discount rate has been a subject of investing debate for quite some
time. In reality there is no correct discount rate to use. Some investors will use the percentage
return that they could earn if they were to buy treasury bonds, others use what they think the
inflation rate will be, and other use the annual percent return that they wish to earn on their
investments. All of these discount rates have good logic behind them and there is not one right
answer for which is the best. Therefore you must choose the discount rate that you prefer to use,
yourself.
When you are using discounted future cash flow analysis to calculate the value of a stock
investment, then you can discount the future earnings, or dividends and stock sale price, or cash
flow or more. Lets assume that you are going to discount the future dividends and sales price
using a discount rate of 10%. Also assume that the stock costs 75 dollars per share and pays an
annual dividend of 2 dollars per share. Also assume that you will be able to sell the stock in 10
years for a price of 100 dollars.
The easiest way (though only slightly inaccurate) to discount by 10% is to multiply each year’s
cash flows by 90% of the previous year. So in our example, the cash flow in year one is a 2
dollar dividend. 2 dollars times 90% is 1.8 dollars. This means that, 2 dollars one year from now
is worth 1.8 dollars to you today. The next year’s 2 dollars of income would be worth 1.62 (2 X
90% X 90%) dollars to you today. This means that 2 dollars 2 years from now is worth 1.62
dollars to you today. The entire calculation including the 100 dollar sale of your stock at the end
of 10 years would look like this.
2X.9 = 1.8
2X.9X.9=1.62
2X.9X.9X.9= 1.46
2X.9^4th= 1.31
2X.9^5th=1.18
2X.9^6th=1.06
2X.9^7th= 0.96
2X.9^8th= 0.86
2X.9^9th= 0.78
(2+100)X.9^10th= 90.70
Add up all of the numbers for a value of $101.72.
This means that all of the money that you will get from this stock over the next 10 years would
be worth 101.72 dollars to you today at a discount rate of 10%.
This is nice since you can buy the stock today for 75 dollars and all of the money that you will
make from the investment is actually worth over 100 dollars. You are basically buying each
dollar for 75 cents.
This whole process is dependent on the assumptions that you make. Using the same example if
you can only sell the stock for 75 dollars at the end of 10 years then the discounted cash flow
value is only $79.22, which doesn't leave you much room to have incorrect assumptions.
So the assumptions that you make are very important, and it is a good idea to do these
calculations using conservative assumptions. It is also a good idea to preform this calculation on
any investment that you are about to make, including stocks, bonds, real-estate, options, and
other. As always you should consult a financial professional before making any investment
moves. It is also a good idea to ask that professional to make this calculation on you investment,
and to have him or her explain his or her assumptions and calculations.

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