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Explain

byrneseyeview 18y ago
He may be suggesting that you buy some Dohar Cattle Feed Company stock (that's what I get when I search Google Finance for 'DCF'), but it's probably a reference to discounted cash flow, a very useful tool for evaluating certain business. The idea of DCF is to split up the value of an investment into chunks of future cash flow, and ask yourself how much you'd pay for each chunk. For a simple example, if you have a business that's sure to pay you $100, once, a year from now, you ask yourself: how much would I have to put in the bank, now, to get $100 on that date? That amount is the present value of that cash flow. Now consider a business that will pay that same certain $100, but after two years. The principle is the same -- how much would you put into a bank account now to get that same $100 on the same date? To further complicate things, imagine that you're betting on a coin flip: two years from now, you will get either $100 (heads) or $0 (tails). To figure out the net present value, you'd first determine the average outcome ($50), then decide how much you'd have to put in a risk-free account now to get that amount in two years.* Put these together, and you can understand the DCF framework. Let's say you have a business that earned $100 last year, and that you expect to earn about 5% more each year thereafter. But in any given year, there's a 10% chance that the business will go under. The discounted future value is that same procedure, repeated for each year: the price you should pay is how much you'd invest in a bank account now for a 90% chance of $105 in a year, plus an 81% chance of $110.25 in two years, etc., or sum(100 * 1.05^n * .9^n * [1 - risk-free interest rate]^n). So now all you have to do is 1) figure out what the business will earn every year from now until the end of time, and 2) figure out the intrinsic value of a given sum of money to be delivered at a given future date. These are both, of course, impossible. But rough estimates get you pretty close to where you need to be, and it provides a good way to compare two stable-growth businesses in the same industry (how much should you pay for a soft drink company growing at 3% each year, versus an otherwise identical company growing at 5% each year, for example?). * This assumes you have an infinite tolerance for risk. But a one in a billion chance of one billion dollars is probably not worth a dollar -- or, rather, it's worth more than a dollar if you enjoy gambling, and less than a dollar if you intend to retire on it. Edit: replaced a second '$105' with the correct number, $110.25.
furiouslol 18y ago
Discounted Cashflow Model is one of the most robust way to value a company (whether public or private). Unlike other models like the dividend model, price/earnings model, a DCF model is flexible enough to value almost all type of businesses (early stage, high-growth, maturing). And its fundamental concept is so simple: You just need to make really good guesses of the future cashflows and discount it back to the present and what you get is the intrinsic value. Assuming this public company is valued at $1 billion but based on your inside knowledge of the company's projected cashflows, you derive an intrinsic present value of $5 billion - it's a screaming buy. Later, as time goes by and the company meets your previous cashflow projections, the market will adjust their valuation to your initial calculation and voila, you're in the money. Other models like P/E and dividend don't work well. Earnings and dividends can be manipulated SO EASILY. Imagine some dying company borrowing lots of cash in order to increase their dividend. Based on the dividend model, its valuation increases. So the only thing you can back your life on is the cashflow. You can't just manufacture cash. DCF can help you explain several phenomenons. Eg. why doesn't Salesforce crash despite its high P/E? Because the bulk of Salesforce customers pay upfront. So there's a lot of cash coming in and that cash has value. So here's a fun exercise for you to do today: Project Facebook's cashflow for the next 10 years and discount it back to the present and compare it with Microsoft's $15 billion valuation. Then you can tell people whether Microsoft overpayed. Happy DCFing!
- byrneseyeview 18y ago
  So the only thing you can back your life on is the cashflow. You can't just manufacture cash. Yes, you can. Read up on Enron's repo agreements. They raised cash by selling assets near the end of the quarter, and promising to buy them back at the start of the quarter -- it was underhanded, but it still showed up as operating cash flow. They did this for t-bills, Nigerian barges, and everything in between. Cash flow quality is higher than earnings quality, but it is by no means perfect.
  - furiouslol 18y ago
    The DCF model adjusts to this situation perfectly. They raised cash by selling assets near the end of the quarter, and promising to buy them back at the start of the quarter So there is an initial cash inflow at the end of the quarter and a cash outflow at the start of the next quarter. Just add that in your DCF analysis. When I say you can't just manufacture cash, I'm talking about free money with no strings attached. In your Enron example, there is a string attached - they have to buy it back in the future, so there is a projected cash outflow in the future. No company can manipulate the books to inject $100 million from the thin air. That $100 million has to come from somewhere - from debt, equity investment, asset sales etc. Earnings is so unreliable. Eg. this company is projected to earn $1 million with annual growth of 10% from Year 1 to Year 10. But they have a major debt ($100 billion) that is due on Year 11. A DCF model would value this company correctly as bankrupt while an earnings model would not be able to value this company correctly.

Explain

He may be suggesting that you buy some Dohar Cattle Feed Company stock (that's what I get when I search Google Finance for 'DCF'), but it's probably a reference to discounted cash flow, a very useful tool for evaluating certain business. The idea of DCF is to split up the value of an investment into chunks of future cash flow, and ask yourself how much you'd pay for each chunk. For a simple example, if you have a business that's sure to pay you $100, once, a year from now, you ask yourself: how much would I have to put in the bank, now, to get $100 on that date? That amount is the present value of that cash flow. Now consider a business that will pay that same certain $100, but after two years. The principle is the same -- how much would you put into a bank account now to get that same $100 on the same date? To further complicate things, imagine that you're betting on a coin flip: two years from now, you will get either $100 (heads) or $0 (tails). To figure out the net present value, you'd first determine the average outcome ($50), then decide how much you'd have to put in a risk-free account now to get that amount in two years.* Put these together, and you can understand the DCF framework. Let's say you have a business that earned $100 last year, and that you expect to earn about 5% more each year thereafter. But in any given year, there's a 10% chance that the business will go under. The discounted future value is that same procedure, repeated for each year: the price you should pay is how much you'd invest in a bank account now for a 90% chance of $105 in a year, plus an 81% chance of $110.25 in two years, etc., or sum(100 * 1.05^n * .9^n * [1 - risk-free interest rate]^n). So now all you have to do is 1) figure out what the business will earn every year from now until the end of time, and 2) figure out the intrinsic value of a given sum of money to be delivered at a given future date. These are both, of course, impossible. But rough estimates get you pretty close to where you need to be, and it provides a good way to compare two stable-growth businesses in the same industry (how much should you pay for a soft drink company growing at 3% each year, versus an otherwise identical company growing at 5% each year, for example?). * This assumes you have an infinite tolerance for risk. But a one in a billion chance of one billion dollars is probably not worth a dollar -- or, rather, it's worth more than a dollar if you enjoy gambling, and less than a dollar if you intend to retire on it. Edit: replaced a second '$105' with the correct number, $110.25.

furiouslol 18y ago

Discounted Cashflow Model is one of the most robust way to value a company (whether public or private). Unlike other models like the dividend model, price/earnings model, a DCF model is flexible enough to value almost all type of businesses (early stage, high-growth, maturing). And its fundamental concept is so simple: You just need to make really good guesses of the future cashflows and discount it back to the present and what you get is the intrinsic value. Assuming this public company is valued at $1 billion but based on your inside knowledge of the company's projected cashflows, you derive an intrinsic present value of $5 billion - it's a screaming buy. Later, as time goes by and the company meets your previous cashflow projections, the market will adjust their valuation to your initial calculation and voila, you're in the money. Other models like P/E and dividend don't work well. Earnings and dividends can be manipulated SO EASILY. Imagine some dying company borrowing lots of cash in order to increase their dividend. Based on the dividend model, its valuation increases. So the only thing you can back your life on is the cashflow. You can't just manufacture cash. DCF can help you explain several phenomenons. Eg. why doesn't Salesforce crash despite its high P/E? Because the bulk of Salesforce customers pay upfront. So there's a lot of cash coming in and that cash has value. So here's a fun exercise for you to do today: Project Facebook's cashflow for the next 10 years and discount it back to the present and compare it with Microsoft's $15 billion valuation. Then you can tell people whether Microsoft overpayed. Happy DCFing!

byrneseyeview 18y ago
So the only thing you can back your life on is the cashflow. You can't just manufacture cash. Yes, you can. Read up on Enron's repo agreements. They raised cash by selling assets near the end of the quarter, and promising to buy them back at the start of the quarter -- it was underhanded, but it still showed up as operating cash flow. They did this for t-bills, Nigerian barges, and everything in between. Cash flow quality is higher than earnings quality, but it is by no means perfect.
- furiouslol 18y ago
  The DCF model adjusts to this situation perfectly. They raised cash by selling assets near the end of the quarter, and promising to buy them back at the start of the quarter So there is an initial cash inflow at the end of the quarter and a cash outflow at the start of the next quarter. Just add that in your DCF analysis. When I say you can't just manufacture cash, I'm talking about free money with no strings attached. In your Enron example, there is a string attached - they have to buy it back in the future, so there is a projected cash outflow in the future. No company can manipulate the books to inject $100 million from the thin air. That $100 million has to come from somewhere - from debt, equity investment, asset sales etc. Earnings is so unreliable. Eg. this company is projected to earn $1 million with annual growth of 10% from Year 1 to Year 10. But they have a major debt ($100 billion) that is due on Year 11. A DCF model would value this company correctly as bankrupt while an earnings model would not be able to value this company correctly.