4) Valuation methodologies: DCF

 

DCF
Fundamental concept: would you rather have $100 today or $100 in one year’s time? Clearly today is better given that you could invest the $100 today in a savings account and have, (at, for example, a 5% savings rate post tax), $105 in one year’s time. This is the concept of time value of money, which underlies DCF.

But let’s take a step back – why is a business valuable? One way of looking at it is that it has assets that you could sell. Hopefully though, the business is worth more than the assets it owns (otherwise its greedy owners should logically shut it down and sell its assets). So where does the value of a business lie? Quite simply, it is a cash factory. A business generates cash, and thus has some value on an ongoing basis (i.e. as a ‘going concern’).

IRR

IRR measures an implied annual return based on an actual investment and an actual return profile. An example: if I invest £10 now, what lump sum do I need to get back in 3 years time to get a 10% IRR? The answer is 10*(110%^3) = 13.31. Hopefully you will recognise the ‘compound interest’ formula here – Initial_invesment x (1+interest)^(num years).

Conversely, a more common question would be “I have an investment opportunity that requires me to invest £10 now and pays £13.31 in 3 years time – what is my IRR?”. Clearly the answer is 10% given our calculation above, however in the general case this is a bit difficult to calculate, and thus it is easiest to use Excel (or a financial calculator) to calculate implied IRRs; in excel, for an initial investment: “investmentYear0″ and a series of cashflows from year 1 to year N: “cashflowYear1:cashflowYearN”, the formula is “=IRR(-investmentYear0, cashflowYear1:cashflowYearN)”

Hurdle rate

Building on the concept of IRRs, a management team will typically have a target rate of return for any investment they make – any investment will have to exceed this rate in order to make sense (see “Cost of capital” for explanation of a typical minimum for this rate). The idea is that there is no point in investing in new projects that generate less ‘real money’ than you could get by investing more in your current projects.

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