Making Sense on Discounted Cash Flow Method of Valuation

Before reading this post, please be aware that you must first recall your knowledge in your first year college class about time value of money or you can check this resource.

I already discussed PE ratio as a simple valuation method in here.

The ultimate determinant of value is the cash that comes in to the owners of the business. Suppose that you own a business, what would matter to you most? The earnings figure in the income statement or the cash that goes into your bank account (figures in the cash flow statement)?

With cash in mind, we can say that in order to value a business we should measure how much cash it will generate in its lifetime. And since we are dealing with years, it is appropriate to use discounted cash flow (DCF) method to value a business.

Let’s say you own a laundry shop that you expect to generate cash to your bank account of P1,000 for 10 years and you expect it to generate P500 to infinity with no growth and is expected to maintain no debt. Let’s assume that our cost of capital is 5%.

The formula of DCF method is:

Intrinsic value = sum of discounted present value + present value of terminal value – net debt

We will have the following calculation for the intrinsic value of the laundry shop:

DCF1

More on DCF method of valuation here.

Assuming that someone will offer to buy your business, you should not sell it at lower than P13,860.

Comments:

You may have noticed that I do not add terminal value in my DCF valuations. The reason being is that I do not believe that companies will go on in perpetuity or exist forever. Also, it provides ample margin of safety for my calculation.

Everything in the book sometimes does not make sense in the real world. 🙂

 

 

Disclaimer: I do not claim to be an expert and nothing I say should be taken as a recommendation to buy or sell. Read more in the ABOUT page.

Disclosure: See Portfolio page for my holdings.

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