Cash Flow Valuation 101
(This blog post is drawn from two lectures prepared for Southern New Hampshire University)
If I could put time in a bottle, you know the first thing that I'd like to do? I'd use it to determine the present value of cash flows, of course! Actually, I'd use Excel, but I digress. Anyway, mastering cash flow valuation, both conceptually and mathematically, will enable you to climb the financial mountain as far as you wish. Let me briefly explain why comprehending cash flow valuation is so essential.
Financial Truth: Any asset's inherent and intrinsic value is based on the present value of its future cash flows. Period. Present value simply describes common sense: a dollar received today is worth more than a dollar received tomorrow. A rational person would prefer a buck today over a buck tomorrow, and a buck tomorrow is more desirable than a buck next year. Why? There are three reasons:
- Inflation gradually reduces the real purchasing power of your money.
- You could earn interest on the money if you have it today and invest it.
- Not to be morbid, but you (or I) might be dead by tomorrow. If you don't receive your dollar until tomorrow, it'd really stink if you died today! You can't take money with you.
Present value is absolutely essential to Forward View's financial modeling and to professional finance in general. If a client asks Forward View to value a bond, we use present value calculations. If equity analysis is needed, we apply present value techniques. As a matter of fact, Forward View values entire corporations using cash flow valuation math. (Consider that a share of stock represents ownership in a corporation. If Corporation X has a present value of $1 billion and has 100 million shares outstanding, how much would each share be worth?)
Now, you're probably hoping I can provide a perfect solution to enable easy mastery of cash flow valuation concepts. Well, there isn't a magic bullet. Nada, zip, zilch, zero. Sorry. I do have a few tips for you, though:
- Practice makes perfect.
- When you think you've practiced enough, practice some more.
- Use Excel to adjust formula inputs with ease. Learning by doing is key.
- There will be a lightbulb moment when everything makes sense. When you have that moment, calculate the value of one more stock, bond or project. Then, quit and celebrate!
- Don't ever stop practicing until your lightbulb moment. (For the record, my lightbulb moment came relatively late in my first finance class.) Timing isn't important—the brightness of your cash flow bulb is all that matters!
Don't forget that present value, and the related future value concept, are inherently logical. Comprehension of cash flow valuation will change your outlook on money, and that's essential. When you combine cash flow valuation with financial statement analysis knowledge, you're ready to be a financial analyst.
The cost of capital is a key, and related, topic for businesses. The cost of capital tells you how much a business pays for its debt and equity financing. That's important because a firm's investments and projects must yield a return greater than the cost of capital in order to be profitable. The weighted average cost of capital (WACC) is best explained by example: If 30% of a company's capital is debt costing 8% (think of interest payments) and 70% of the capital is equity costing 4% (think dividends plus other costs), the WACC would be: (30% * 8%) + (70% * 4%) = 5.2%. Simple, huh? You can also use the WACC to discount cash flows to get their present values. The Forward View valuation model uses this exact methodology, along with the incorporation of historical data and a regression analysis. The related marginal cost of capital (MCC) simply describes the cost of a company's next dollar of capital.
I wanted to share these concepts here in order to disseminate general financial knowledge and to explain more about Forward View's approach to financial analysis. Our business model is built around the application of academically-rigorous methodologies that are then applied to practical business problems. We believe that such fundamental research can uncover mispriced securities in today's markets. Furthermore, Forward View utilizes similar conceptual and quantitative strategies to value businesses and capital projects. We truly look forward to delivering analytical solutions to your firm in 2015 and beyond.
Owner and Director of Research