September 24, 2020
Discounted Cash Flow
All companies are worth exactly the sum of their discounted cash flow; The sum of all monies spent or earned into the company discounted into today’s value. The discount rate, which changes over time accounts for inflation, risk, and riskless interest.
Where r is the discount rate. You will notice that this formula is always discrete. There is no integration that makes sense because cash transfers into or out of the company must always be of a discrete type. Sometimes an integral is useful for simplification purposes.
While this formula has limited utility for calculating the value of a business. There are some interesting aspects that can inform your valuation experience.
- All things being equal, business valuations fall as riskless interest rates go up.
- All things being equal, business valuations fall as risk whether systemic or specific go up.
It is not typical to see DCF as a valuation method because of its complexity, it may be useful for simple businesses that have well- understood revenues and expenses.
Often you will see this formula simplified with just a single value for the discount rate. Many people have developed curves that establish the expected return for a given risk. The return also is affected by the type of risk. If the risk is uncorrelated with systemic risk or negatively correlated then the expected return is greater. In the end, the discount rate is set by the market; it is what a buyer is willing to pay. Which gets us to a valuation technique that has a bit more utility.
Written by Scott creator of Valtrace.
