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Finance allah shmoop What is discounted Cash flow money air

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gets your money on sale discounted money Yeah kind of

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sort of like that but how can cash be discounted

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and what is flowing anyway Is this like a scene

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from huck finn goes to wall street so the cash

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we're talking about here is cash in the future Got

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it Your company the spice in ator ink sells a

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product that takes any item of food and runs it

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through a processor which makes it pumpkin spice flavor You

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are hated by starbucks everywhere So spice in aitor is

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going to make ten grand by the end of this

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year Fifty grand by the end of next year and

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for five hundred grand by the end of the following

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year and a million bucks by the end of the

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next All right that's not revenues that's profit Or at

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least so you you think it's going to earn a

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million bucks you estimate you guess you hope All right

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Well the value of a company in professional wall street

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he circles is the sum of the parts of its

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future cash flows or cash profits than discounted back for

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risk Meaning it might not actually earn that million dollars

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in four years and time What if those forty years

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or ten years or two years Alright all this means

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that spice in ator ink earning half a million bucks

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in three years is an estimated number It's not certain

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it's hope for begged for prayed for even at least

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in the red states but there is risk It doesn't

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happen Maybe there's thirty percent on that produces three hundred

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grand in profits instead of five hundred grand but ten

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percent odds It produces a million dollars instead of that

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five hundred grand and years out So calculating that risk

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and then discounting it in the value of the company

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Today is a big part of valuing a business parts

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that's the risk side But then there's the time side

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you have to think about as well If you had

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a company you were certain would make half a million

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dollars in profit thirty years from now you know like

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shmoop well that wouldn't be as impressive or valuable as

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a company You were equally certain would make half a

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million dollars in profit next year So that's the time

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component let's add up the notional value of this company

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just as an illustration here Alright Your company's spice in

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ater at the moment has no cash your debt and

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is for illustrative purposes on lee So don't get all

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technical on us and wine about details Try to glean

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a concept here okay So spicy nature will make ten

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thousand Dollars this year in profits it's january now in

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twelve months were eighty percent certain it'll make ten grand

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in profit All right now if we bought the safest

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bond in the world a one year u s treasury

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bond we get three percent interest We fight a discount

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on a thousand bucks Okay that number's serves as kind

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of a bassline whenever we do these kind of analyses

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the u s treasury paper is in generally riskless question

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how much riskier is our company Above and beyond the

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t bill I even company makes that ten thousand dollars

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like could it only make five thousand sure couldn't make

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nothing couldn't lose money Sure couldn't make way more than

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ten grand maybe twenty thirty forty grand Regardless there is

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risk here So the value of that ten thousand dollars

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a year from now carries what is called a risk

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premium tacked onto that three percent figure We're gonna divide

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by it So adding risk premium makes the present value

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less All right let's say that extra risk is pretty

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high like twelve percent That company produces meaningfully less than

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ten grand and profits All right well we discount back

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that One year from now figure of ten thousand dollars

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to be less right Well here's the math you take

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the amount expected to be earned Yes that is the

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cash flow ding ding ding and you divide by one

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plus the quantity of the risk free rate that t

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bill three percent thing plus the risk premium which we've

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guest is in twelve percent So what is the risk

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adjusted and discounted cash flow of ten thousand dollars expected

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or estimated a year from now worth today Well it's

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ten grand divided by the quantity one plus point zero

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three plus point one teo or divided by one point

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one five to the first power for this one year

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away and it looks like that which equals a bit

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under eighty seven hundred bucks So wow Interesting It means

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that the risk of getting that ten grand a year

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from now is high In fact it is worth roughly

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thirteen hundred bucks less today Because of that risk or

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set another way our analysis would suggest that you'd be

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risk neutral if you took a cashier's cheque today for

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eighty seven hundred bucks versus waiting a year and getting

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that Ten grand pay then But if you did wait

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well you'd have a very nice fifteen percent ish return

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on your invested money All right Welcome to risk people

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This is investing Wanna one's order and no extra charge

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from the kindly loving people it's mum inside All right

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And as you'd guess you can get to the total

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value of the company by adding up and then discounting

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future years cash flows of this company in the same

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way when we have the ten grand number already What

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about the fifty k two years from now Well since

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we are comp pounding investment returns we make a call

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too Exponents land with e ticket there all day passed

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And to discount the odds of that fifty k coming

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to us two years from now we apply a similar

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calculation on lee Now we think that the odds of

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fifty k in two years are even riskier than they

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were before Will attach a seventeen percent risk premium toe

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actually getting out fifty grand a profit out of our

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product And we have to discount it back on top

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of the safe or risk free rate of three percent

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Well how's that work well we have fifty thousand bucks

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coming to us We think and hope and pray two

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years from now We then divided by one plus point

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zero three plus the risk premium of point one seven

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squared or to the second power Why Because it's two

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years of compounding away not one Remember I kind of

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mumbled that one year to the first power thing was

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clever on Alright that's Fifty grand over the quantity One

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point two square or fifty grand over one point four

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four or carrying a present discounted value of fifty k

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divided by that one point four four which is a

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little under thirty five grand Well if we carry this

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forward a year and there's even more risk for the

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fur five hundred thousand bucks we expect in three years

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Well then we get something like a risk premium of

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say twenty two percent tacked onto the safe rate of

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three percent or twenty five percent total And we discounted

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back three years or cubed if it looks like this

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Five hundred thousand dollars divided by the quantity one plus

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point oh three plus point two two to the third

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power Or that's five hundred thousand dollars over one point

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two five cubes Which is almost to telling us that

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the present value of that highly suspect five hundred k

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in profits supposedly coming in from spice in ator was

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about five hundred thousand over too or just over two

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hundred fifty grand in present value today Got it Well

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same holds true for that million dollar year and calculate

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the discounted cash value of that million bucks four years

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from now you follow the same pattern and add in

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the million bucks divided by the quantity one Plus you

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know all the other crap in there Yeah So if

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we're getting the total discounted cash flow valuation of the

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company we just add everything up including a sale of

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the company at the end Like if we sold it

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for two and million dollars six years from now we

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discount that back with some you know premiums and someone

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loaded in so that ten million's not a sure thing

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at all We have to assume our guests or dark

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board with blindfolds on the value of the company overall

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will hold for five years from now And yeah that's

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How This kind of cash flow works at least the

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one point overs you're learning here So just be careful

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when you throw that dart You don't want to force

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your business partners to rock and ipad shit no matter 00:07:57.755 --> [endTime] how much that looked cool Oh

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