A Simple Way to Look at Discount Cash Flow

TSMLFor me, value investing is the only logical approach to investing. I recently wrote about how the price you pay for an asset will determine its rate of return, using a condo as a simple example. It really is as simple as that: you need to determine the rate of return you are seeking and then calculate the appropriate price to pay for the cash the asset will generate into the future. Value Investors will talk a lot about discount cash flow analysis. I’ll show you a simple way to look at discount cash flow and how it connects to the price of an asset and the rate of return you are seeking. If you’re still feeling slightly confused, don’t worry, let me show you what I mean by using the ad revenues of this website to determine what price you would need to pay to purchase this asset’s cash stream.


 

Going on Google AdSense data from October 2014 to February 2015, Kapitalust has generated on average $0.14 a day in ad revenue.

Now, to keep things simple, let’s ignore expenses (such as hosting costs) and use only the cash that is generated from the ads. To further simplify, let’s use this $0.14/day average and imagine that this is what this site will generate for the next 3 years.

Why 3 years? I just wrote about how I saved 50% (you could even say $36,000) by haggling with BlueHost for a heavily discounted 3 year hosting rate. Kapitalust will go on for at least 3 more years.

These are the facts we’re working with:

  1. The asset generates $0.14/day
  2. The asset will generate a total of $153 at the end of 3 years ($0.14 x 3 years)
  3. We will assume inflation to be 2% over 3 years
  4. After 3 years, you will close up shop and no longer collect any cash from this asset.
  5. For simplicity, we will ignore expenses, taxes, and focus only on the cash generated.
  6. For further simplicity, we will think of the $153 as the future value of a single sum.

Now, since we know that Kapitalust will generate $51 this year, $51 in 2016, and $51 in 2017, we need to discount $153 (the future value of the cash generated by this asset) back to the present.

Simple.

We use the formula PV=\frac{FV}{(1+i)^{n}} where PV is Present Value, FV is Future Value, i is the discount rate, and n is the number of years.

PV = 153/(1+0.02)^3 = $144

Therefore, the Present Value of the cash Kapitalust will generate for the next 3 years is $144 assuming 2% inflation over 3 years.

Now, the fun part. Just as I showed with the condo, the price you pay for an asset will determine its rate of return.

Let’s say you are interested in buying Kapitalust and the 3 years of cash it generates. If you pay $144, well that was a terrible investment because you got a 2% nominal and 0% real return on investment.

However, if you were seeking a 10% return on your investment, what would you have to pay?

Using the same formula, you would have to use a discount rate of 12% (2% for inflation and 10% for the returns sought):

PV = 153/(1+0.12)^3 = $108.90

This means, if you demand a 10% return on your investment, you cannot pay a penny more than $108.90 for Kapitalust.

If you bought Kapitalust for $108.90 and the site earned you $0.14 per day for 3 years, you would have gotten yourself a 10% return on investment. 10% real return is nothing to sneeze at in investment terms.

It’s as simple as that. Well, the general concept is as simple as that. This is value investing at its core. You never overpay for an asset, unless you are seeking mediocre or sub-optimal investment returns.

Now, we’re off to the Oregon coast for a little winter vacation. Surfing, reading, and relaxation. Sounds like paradise.

16 thoughts on “A Simple Way to Look at Discount Cash Flow

  1. I like the fact you explained the post with some math formula and calculation. Great stuff! Enjoy Oregon, hopefully you don’t get stuck too long in the border traffic. 😉

    1. I might go into detail in a post how I go about looking at potential investments. In a general sense, I like at least 10 years of data – EPS, dividend growth, revenue, net profit, ROE, ROA, ROC, etc – and compare it to industry peers and the industry average.

  2. Steve,

    Well-written and detailed post. Love that you linked the theory back to your own blog income.

    How about I take Kapitalust off your hands for $108.90? 😉

    Have fun in Oregon,
    NMW

    1. Hehe $108.90 is tempting but I think I’ll hold on.

      People who hustle, buy-and-sell, and manage blogs do these calculations to gauge whether a potential web asset is worth it or not. It’s all very interesting.

  3. Hey Steve, hope you have a fantastic time in Oregon. I hear it is a lot like England, sort of.

    Great post. Really good idea to use good old Kapitalust itself for the example! Makes you think doesn’t it? e.g. Can I cover my blog expenses with my ad revenue?!

    Cheers

    1. A lot of blogs I read, especially the ones that have gotten quite the following, implement ads to pay for the increased hosting costs of heavy traffic.

      Some bloggers insist it’s a sell out to have ads, but I’d rather at least have hosting covered by ad revenue as a lot of time and dedication is put into writing content for free.

      1. I couldn’t agree more. I’m now at the point where ads are covering my hosting, and I’m pretty happy about that. It’s not cheap, once you factor in an URL and maybe some premium services such as a premium WordPress design etc.

  4. This is a good illustration about discount cash flow. My comment has nothing to do with the concept however 😉

    To me, knowing the concepts is important. However, knowing concepts and applying them are two separate things. To take it one step further, it is possible that a “skilled operator” (not me) could buy KL for top dollar at $150 and extract “value” by shutting it down, and “selling” articles out there.

    For example, I could “sell” your article on Coca-Cola to Seeking Alpha and earn $35 guaranteed.

    Or I could put links to payday loans, and earn that $150 back quickly. Who cares about ranking – I am a barbarian at the gate 😉

    Of course, what I discuss is short-termism, where the current price does not accurately reflect underlying values. Your goal is probably to grow the site over time, and earn much more over time from it than 14 cents/day.

    1. Thanks for the insightful comment DGI – much appreciated!

      I think for most beginners, thinking of future growth of a fantastic business (definitely NOT Kapitalust :P) statically based on the TTM or very conservative growth rates builds a sort of margin of safety – it should help with reigning in magical thinking.

      You are completely correct that there could be much more short term value by paying $150 for the site, shutting it down, and selling the articles online piece by piece. That’s an interesting idea actually.

      You’ve been around at least since 2008, have you been successful integrating DGI with Seeking Alpha? Do you get to use the same articles you write on DGI for SA? Are the rewards worth the time and effort? Would it still be worth it now vs. starting in 2008?

      1. Hi Kapitalust,

        My comment was more about how DCF is helpful, but also it is
        helpful to look beyond cashflows and hopefully find value elsewhere as well. I
        used your nice site as an example with an asset that has decent cash flows, but
        also has a good article library. I think Buffett thought in a similar way when
        he looked at Disney in 1965. (I am not Buffett, but I have read about him some –
        check his 1991 speech).

        For example, a company with a lot of real estate could be
        breaking even, but it could “unlock” the value of the real estate by setting up
        a REIT and spinning it off to shareholders. People are crazy about REITs these
        days. One of the most popular authors on SA writes about REITs.

        Either way, your article is very good. Keep posting. I am
        happy I found you on innerscorecard’s site.

        1. Is this something MCD could “potentially” do to unlock the value of all the RE corporate headquarters owns? Is there more long term value in MCD keeping the RE as is or spinning it off as a REIT?

  5. Could you do this same concept for a stock like GIS, for example? What figures do you use in the calculation, earnings? Cash flows? Are dividends included? Just curious, I haven’t delved into DCF even though it is such a starting point topic!

    1. This is really just a rough, back of the envelope, rule of thumb, Ben Graham’s fat man test. I think there’s danger in precision as when you really get into detailed discount cash flow analysis, it becomes too easy to tweak things to get the outcome you want. You could use this rough line of thinking for GIS and it would probably let you know if the businesses is fat or not – but it won’t give you the precise weight (imo, a “precise” weight probably doesn’t exist, just varying degrees of opinions of the precise weight).

      @dividendgrowth above made some good points about how DCF is a starting point, but there are other ways to value a business depending on what your motives/goals are (ex. perpetual business or corporate raider).

      Hopefully I haven’t confused you too much with the cryptic metaphors.

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