Discounted Cash Flows (#214)
/In this podcast episode, we discuss when to use a discounted cash flows valuation, as well as its advantages and disadvantages. Key points made are noted below.
Discounted cash flows are when you project out a stream of cash flows into the future, both incoming cash and outgoing cash, and use a discount factor to come up with a net present value for the cash flows. The net present value is what those cash flows are worth right now.
When to Use Discounted Cash Flows
There are two situations where it’s useful. The first is when you want to acquire another business. There might be all kinds of strategic reasons for doing an acquisition, but ultimately the discounted cash flows generated by the acquisition have to at least match the amount paid for the acquisition. Otherwise, you lose money on the deal.
The second situation is when you want to invest in an asset that’s going to generate cash. I’ve pointed out in some other episodes that the main point to investigate for an asset purchase is how it impacts the bottleneck operation of the business. Nonetheless, you still need to perform a discounted cash flows analysis.
So those are two situations in which it’s useful. In addition to that, the analysis is more useful when interest rates are really high. The reason is that the discount factor can be enormous in countries with high interest rates, which results in net present values for longer-term cash flows that are far lower than you might think.
In the reverse case of low interest rates, the discount factor could be close to zero, though management might layer on a few percent to account for the riskiness of cash flows. In this case, the sum total of the cash flows could be about the same as their net present value, since they’re barely being discounted at all.
In general, you should use discounted cash flows analysis whenever the cash flows are supposed to extend out into the future for more than one year. Or, if interest rates are really high, consider using it for even shorter-term cash flows.
Advantages of Discounted Cash Flows
What is the advantage of discounted cash flows? The main point is that it gives you a reality check. There might be all kinds of other reasons for evaluating a business acquisition or an asset purchase, but over the long term the company will lose money on these purchases if it hasn’t been paying attention to cash flows.
The reason that’s always given for paying high prices is that a purchase is strategic. That usually means the price is way too high, and that the business will never earn back the investment, but that making the investment will put the company in a better strategic position. My response is that good strategy results in better cash flows. So if a purchase is classified as strategic, it should have even better discounted cash flows than normal.
Disadvantages of Discounted Cash Flows
What is the disadvantage of discounted cash flows? There’re several items. First up is how difficult it can be to predict cash flows. After a couple of years into the future, the accuracy level declines dramatically. And yet, the standard analysis always seems to run for about five years into the future. The people creating those forecasts are guessing. Sometimes wildly. The way to get around that is to do a high, medium, and low cash flows analysis, and pay particular attention to the low cash flows scenario. From what I’ve seen over the years, you should assign about a 50% probability to the low cash flows scenario, since actual cash flows tend to be lower, not higher.
And sometimes managers just lie when they’re constructing cash flow projections. They figure out the discounted cash flows figure that they need, and then adjust their cash flow projections to make sure that the calculation yields that number. This is really an ethical problem, rather than a cash flows problem. Having a code of conduct and coming down hard on the people who do this should send the right message.
Derivation of the Discount Rate
The discount rate is derived from the cost of capital of a business, which is the cost of its debt, preferred stock, and common stock. There’re so many variations on how to calculate the cost of capital that you might end up with a discount factor that’s wrong – which means that the net present values derived with it are also wrong. For example, the interest rate on just the debt part of that calculation could be based on the forecasted interest rate on the next debt issuance, or the current average rate on debt outstanding, or the company’s historical rate of interest.
The best approach is to use the incremental interest rate that’s most likely to apply to the specific acquisition you’re looking at. So, for example, if another million dollars of debt will only be taken on specifically to buy the asset being analyzed, then the cost of that specific debt should be used in the cost of capital.
The Assumed Income Tax Rate
Another issue that can result in a bad cost of capital is the assumed income tax rate. The cost of debt is its after-tax cost, so you have to figure out in advance what the marginal tax rate will be that applies to the specific transaction that you’re modeling for.
Derivation of the Cost of Capital
And to make matters even worse, the cost of capital is based on the weighted average amounts of debt, preferred stock, and common stock. But is this the targeted amounts of debt and equity that will be on the books at a later date, or the current market values of debt and equity, or the book values of debt and equity? You probably want to use the current market values of debt and equity, but there are arguments in favor of the other options.
The Risk Premium
And then, many organizations like to add a risk premium onto the cost of capital to arrive at the discount factor they want to use for a discounted cash flows analysis. If the ability to generate the cash flows is considered unusually risky, then the risk premium is higher. If the cash flows look solid, then the risk premium is lower or nonexistent. The risk premium isn’t quantified at all – it’s just a guess. And it could be used by managers to make the net present value of project they don’t like look even worse.
What I prefer to do is not use a risk premium at all. Instead, use that high-medium-low approach I noted earlier, so there’s a model that lays out the worst-case scenario.
Parting Thoughts
I’ve made a few suggestions here for how to create a reasonable discount factor, but this is still a major weak link in formulating discounted cash flows. The discount factor could be off by a lot, which results in misleading net present values. And that is certainly a disadvantage of this method.
In summary, there certainly are some issues with discounted cash flows, but it’s still one of the primary tools used to analyze larger purchases.