Part 2 of 2 – Read part 1 here.

(Continued from part 1)

What is the value of my company today?

Present value and the time value of money

By using various methods, the value of a company's future cash flows is translated into their value as of today.  Today's value is often referred to as the "present value."

A simple example will help define and clarify the concept of present value.  Assume I promised you $5,000 five years from now. The concept of present value asks the question, "what is the value today of $5,000 to be received in five years?"  Some would answer $5,000, but that answer ignores "the time value of money."

Here is the theory behind the time value of money.  First, consider the fact that, if you had the $5,000 I promised right now (rather than five years from now), it would be worth more in five years because you could invest it during that period at a rate of return of, let's say 5%. (Ignoring the calculations, $5,000 invested today, earning 5% interest, compounded annually, would be worth almost $6,400 in five years).

Now consider the same concept from a different perspective.  If you invested $3,900 today, earning 5% per year, that amount will be worth $5,000 in five years.  So, if I gave you the choice of receiving $3,900 today or $5,000 in five years, it wouldn't matter which one you chose.  Either choice would result in you holding $5,000 in five years.  Stated differently, assuming you could earn 5% per year, $5,000 to be received five years from today is worth $3,900 received today.  The present value of $5,000 in this scenario is $3,900.

Discounted cash flows

The process of converting future cash flows into their value as of today is referred to as "discounting cash flows."  In general, discounted cash flow analysis is one of the foundations of finance theory, as well as a commonly used method in valution.  The following highly-simplified example illustrates the process.

Example

Assume your company's free cash flows were $100,000 this year, and are expected to grow by 10% per year (indefinitely for purposes of simplicity).  Assume further that a potential buyer has determined that, based on various factors, including risk, if he or she were to purchase your company, they would require an 20% return on their investment.  This percentage, 20% in this case, is often referred to as the discount rate.

Without going into the theory behind the math, the formula for valuing your company (simplified for purposes of this example) is as follows:

Value = FCF/(D-G), where: FCF represents free cash flows; D = the discount rate (or required rate of return); and G = the growth rate of those free cash flows

Using the numbers from the example: $100,000/(20% – 10%) = $1,000,000.  In essence, the value of your company today is $1,000,000, based on the parameters defined in the example. 

In looking at the formula, you'll notice that if cash flows (the numerator) increase, valuation increases.  

Valuation and risk

The formula's denominator is represented by the investor's required rate of return minus the expected growth rate in cash flows, expressed as a percentage. As this percentage increases, the valuation decreases.  For example, if the discount rate were to change from 20% to 25%, the formula result would be $100,000/15%, or $666,667.  A decrease in the anticipated growth rate would also produce a lower valuation.

If the earnings growth rate decreases, it seems logical that the total value would decrease – less growth in earnings = lower valuation.  But why does the value decrease, in this case significantly, if the discount rate increases?  In this example, the value of the company decreased from $1,000,000 to $666,667 when the discount rate increased from 20% to 25%.

In essence, the riskier the investment, the lower the value. If the investor in the preceding example determined that there was a higher level of risk associated with the company, he or she would be willing to buy it, but for a lesser price.  

 If your friends, Joe and Jack, offered you what appeared to be identical investments in their respective ventures, you'd most likely pay less for Jack's because you know he is the riskier of the two.  Without being necessarily aware of it, you have assigned a higher discount, or rate of risk, to Jack's offer, which in effect, lowers its value. By paying less, you'd be demanding a higher rate of return from Jack, i.e. additional consideration in exchange for assuming more risk.

In conclusion, although often expressed using different terminology, the value of a company, or any investment for that matter, is a function of its future cash flows, discounted to their present value (today), based on a specified level of risk, and the rate of return required by a prudent investor.

Tagged as: discount rate, discounted cash flows, future cash flows, Present value, time value of money, valuation and risk