0:17

A discounted cash flows is often considered the most

Â thorough way to valuate a company.

Â Discounted cash flow uses the company's free cash flows and

Â a discount rate to calculate what we call the NPV, or net present value.

Â And this is not only used for companies but it can also be used for projects.

Â It can be used for individual investments, it can be used for portfolios, okay?

Â 0:59

Let's talk first about net present value.

Â What is net present value?

Â Net present value takes into,

Â to consideration the concept of the time value of money.

Â What's the time value of money?

Â Quite simply, money today is worth more than money later.

Â Right, money now is worth more than money later.

Â If you give me $100 today, and I promise to repay you that $100 a year from now,

Â you've lost, because a year from now,

Â $100 is not gonna be worth what it is today, for a couple of reasons.

Â One, there may have been inflation, and $100 is worth a little bit less.

Â And also, there's the benefit that you could have made with that $100.

Â So money more is worth more than money later.

Â 1:43

So how much more, right?

Â What, what, what is, how much more is money worth a year from now than today?

Â It's not just the inflation rate.

Â It depends on who has that money, how they're gonna use that money.

Â It depends on what we usually call our next best investment, or

Â next best opportunity.

Â So, there's a few different ways we do this and

Â there's a few different titles we give it.

Â The, the, the cleanest one is when we're evaluating a company,

Â we're looking at the discounted cash flows of a specific company.

Â Let's go back to the Gap, for example.

Â If I looked at the Gap, and

Â I wanted to know what is Gap's money worth today as opposed to later?

Â I wanna know how much money costs them, okay?

Â There's another concept.

Â Money costs us.

Â When I get money from somebody, I have to pay for that money.

Â You gotta buy money.

Â You gotta buy money at more than you're buying it for.

Â When you go out to buy a car, and you get a car loan, right?

Â Some bank gives you a loan.

Â You pay them back more than they gave you.

Â Why?

Â Because money costs more than what you're getting, right?

Â You, the, the premium on the money that you're paying,

Â you think of as your interest rate.

Â What's my APR, my annual interest rate, 'kay?

Â That's what you're paying for your money.

Â Well, what does Gap pay for their money?

Â Well, it depends where they get it from, right?

Â What are the main sources of money?

Â 3:06

There's debt and there's equity, 'kay?

Â Debt is when Gap goes to their banks and says, hey, we'd like to borrow money,

Â 'kay, and the bank says, sure.

Â We'll loan you this much.

Â Here's your, here's your interest rate, which is usually decently low,

Â especially for a huge company like Gap.

Â There's another way that Gap can get money also.

Â They can go to the market.

Â They can get investors.

Â That's equity.

Â They can basically sell stock.

Â Now, in business rule of thumb, debt is cheaper than equity.

Â I've said that before already.

Â Debt is cheaper than equity.

Â 'Kay, so it costs us less to go to the bank than it does to go in the market,

Â which is why in the last section where I was speaking about the last module and

Â we were doing ratios, spoke about the debt ratio, right?

Â And we actually like to see about two times as much debt as we have equity.

Â So we have $1 million in equity, we'd like to see $2 million of debt, right?

Â Two to one is a nice ratio there that the market tends to like.

Â 4:05

Well, why not all debt?

Â Well, all debt, and you're extremely leveraged, you might have trouble

Â paying back some of this you know, sa, some of this money that you owe.

Â Because the thing about debt is debt usually has a payment schedule attached to

Â it, gotta pay on time.

Â Whereas equity, it's investment, you only pay your owners if you make money.

Â When you make money they expect more, okay, so debt is cheaper than equity.

Â So Gap has two ways of getting money.

Â They can issue, they can, they can accept, they can get some debt or

Â they can get some equity.

Â 4:41

So what's this costing them.

Â In the case of Gap or any other company, any other publicly traded firm and even

Â some non-publicly traded firms, we have a method called WACC, the weighted average

Â cost of capital, which I'll explain a little bit more about as, as we move on.

Â The weighted co,

Â average cost of capital is going to be that company's discount rate.

Â The discount rate is kind of like their APR, right?

Â It's what they pay from money.

Â So when we calculate the weighted average cost of capital,

Â we can discount their future cash flows by that amount of money,

Â right, and see what it's worth in the future.

Â Okay, so money now is worth more than money later.

Â The essence of NPV, how does this work?

Â Let's go back to our Gap example, right?

Â I'm the I'm the CEO of Gap, or the, ma, I'm on the board of directors, and

Â Gap is looking at buying another company, right?

Â And buying another company, and maybe they manufacture some clothes, or

Â design something, whatever, there's a company out there and

Â we wanna, we wanna purchase that company.

Â Is this a good investment?

Â Is purchasing that company worth it?

Â Well we're gonna have to do a couple things first.

Â First, we're gonna wanna look at that company's cash flows.

Â And more importantly, we're gonna wanna look,

Â we're gonna have to project that company's cash flows.

Â Because that company,

Â if we buy it, probably will run a little bit differently.

Â In fact hopefully it will be a lot better company once they belong to us.

Â So we're gonna project their cash flows, okay?

Â 6:12

And then we're gonna, and we're also gonna have to look at how much

Â are we willing to pay for that company, what do we want to buy it for.

Â So we have what we're thinking of as a purchase price,

Â right, which is our investment.

Â We've got projected cash flows, what we believe that company is gonna bring in.

Â 6:28

And now we need to look at what does money cost us?

Â So we simply calculate our WACC.

Â We call finance, and we say, hey, what's our WACC and

Â they better know it off the top of their heads, really.

Â And they tell us, okay, our WACC is 12.4%, whatever our WACC is.

Â And we discount those cash flows by 12%, by our WACC.

Â 6:48

And we get an NPV, we get a number, a net present value.

Â Now if that NPV is zero, very unlikely, right, but

Â if they had zero, then that means we make no additional money.

Â This is break even, right?

Â We make no additional money by in, by engaging in this investment and

Â we lose no money.

Â So really, because of the risk that's always involved in an investment,

Â I would probably not touch it if the NPV was zero.

Â If the NPV is negative, then that means that the money would return to us,

Â is worth less in today's money than the money we've put in.

Â And this is why we discount cash flows.

Â Cuz you could look and say, oh, but we're buying that company for $1 million.

Â And if we just, if we just sum up the cash flows that we get over the next five

Â years, that comes to $1.5 million, right?

Â So 1.5 million, we've made $500,000.

Â No, no, no, no, no because money now is worth more than money later, and it turns

Â out, possibly depending on how that money comes in, and the discount rate, it could

Â be that that 1.5 million discounted is less than 1 million in today's money.

Â In which case, it's a bad investment.

Â Or, the NPV comes back positive.

Â NPV comes back at, you know, $300,000, $200,000.

Â It comes back greater than zero.

Â If it comes back greater than zero, then that means it's a good investment for us.

Â Because currently we're paying 12.4 whatever I said,

Â 12 point something percent for our money.

Â And assuming that that's what this money costs us, that, that we're investing,

Â we've actually brought back more money in.

Â So that's the concept of NPV.

Â We're looking for something that greater than zero.

Â 8:33

So as I've said, there's NPV, which we get from discounted cash flows.

Â Now we can also calculate, from those same, from the same cash flows,

Â we can calculate what's called IRR, the internal rate of return.

Â Now NPV gives me a monetary value, right?

Â It says that this investment is worth, in today's money, $200,000,

Â $300,000, whatever it is, right?

Â Because the money that I'm gonna get back from that company,

Â once discounted, is worth this premium.

Â So that's what it's worth to you, okay?

Â IRR is gonna give you a percentage.

Â It's almost as if this is you, the rate of return on your money.

Â In fact, internal rate of return, that's what it is.

Â It's the percentage rate of return.

Â So we run IRR the same one way we run NPV.

Â We use the Excel function.

Â We say IRR equals, and we try to get that.

Â And IRR will then say, for example, 21%, right, and

Â that's the rate of return on the money.

Â Now we can also take that and compare it to our WACC, right, our discount rate.

Â If the IRR is greater than our discount rate, it's a good investment.

Â If the IRR is less than our discount rate, it's a bad investment.

Â We're gonna lose money, okay?

Â I like to do both, I like to perform both NPV and IRR.

Â 9:58

Entrepreneurs, investors usually like NPV, they like that monetary value.

Â Now since NPV actually yields a dollar amount, only NPV can be used

Â to valuate company, give you an actual value of what that company is worth.

Â There's also, there's a problem with that IRR.

Â 10:18

And you can get out of this problem if you really wanna take an advanced math

Â class and learn the equations in calculating IRR, you can get around this.

Â But if you're like me and you're gonna use Excel to calculate NPV and IRR,

Â Excel can sometimes the, the embedded formula can have a problem with IRR.

Â If cash flows go po, go, they start negative always cuz you make an investment

Â so it's starts negative, it goes positive, if it goes negative again and then goes

Â positive, your IRR may be flawed, right, might, might not, you don't know.

Â But it may be flawed.

Â If that's the case then you have to use NPV because IRR doesn't make any sense.

Â You actually can check it.

Â Okay, so remember when I said that you want the IRR to be big,

Â to be greater than your discount rate.

Â If it's greater than your discount rate, you're making money.

Â This is because there's a,

Â there's a relationship between the discount rate and IRR.

Â IRR, if you make the IRR your discount rate, so change it from whatever

Â your WACC is to what the IRR is, your net present value should be zero, okay?

Â Cuz that's the actual discount rate of the, of the money to,

Â to make the NPV equal zero.

Â So you can check your IRR.

Â 11:39

Take whatever Excel says your IRR is,

Â put that in as your discount rate in your net PV function and,

Â your net, your net present value should be pretty close to zero.

Â Sometimes it can be up or

Â down a little bit because you're not putting in enough def, decimals.

Â But if you actually just copy and paste the equation,

Â it should actually equal zero.

Â So you can check the IRR in the event that you have fluctuating cash flows,

Â to make sure that NPV, that Excel is properly calculating it.

Â So that's a very brief, a basic overview, of how you use

Â cash flows to valuate a firm, by discounting them with the discount rate,

Â which we've been calling the WACC, the weighted average cost of capital.

Â Now there's also, in the times when we don't say WACC, we just say discount rate.

Â Because, how about if I, if, if I want to invest in a project, what's my WACC,

Â right?

Â I'm not gonna call it a whack, right?

Â It's gonna, I'm gonna call it my discount rate.

Â My discount rate is going to depend on a couple of things.

Â First of all, I don't issue stock in myself, right?

Â So there's no market out there, right, people buying equity in me.

Â What I have is I have my next best opportunities, right?

Â What's the bank gonna give me if I take my $20,000 and put it in the bank,

Â what's the bank gonna give me?

Â If I take and loan it to my brother, what's my brother gonna give me,

Â right, if I charge my brother interest?

Â 13:00

What can I do with this money, right?

Â There's also what kind of risk do I associate with this money?

Â 'Kay, if I'm gonna give you money to start a business, how risky do I think that is?

Â So, I'm going to decide what a discount rate that I want.

Â And, that discount rate basically, is a monetization of risk.

Â 13:21

And, it's the same with, with WACC.

Â WACC is simply a monetization of risk.

Â It's how the market the, the, the, the equity market and

Â the debt market evaluate the risk of that company.

Â Okay, so that's the discount rate.

Â And you can Google this, you can research this a little bit more and

Â understand it a little bit more, but finding the discount rate,

Â understanding the discount rate is important, not just for a, a a company but

Â even more importantly really for yourself.

Â Is what is my discount rate, what do I expect as a return for

Â the money that I invest?

Â Now in case you're wondering, and

Â I wasn't gonna show you the, the big complex formula or anything, but

Â I do wanna show you really quickly how a very simple WACC would be calculated.

Â We say weighted average cost of capital.

Â Okay, so we have to weight the average.

Â Basically let's look at a, a company.

Â The company has 45% debt at 6% interest.

Â So 45% is, is debt at 6%,

Â 55% is equity at 13%, right?

Â Debt is cheaper than equity.

Â So their WACC is going to be the weighted average 45% of [SOUND] times 6%,

Â 55% times 13%, and that's gonna give us a weighted average cost of capital of 9.85%.

Â So that would be the discount rate that that company would use,

Â and they would want any investment that they got into

Â to have an IRR greater than 9.85%.

Â And using 9.85% as their discount rate,

Â they would want NPV to return a value greater than zero.

Â That's how you calculate a discount rate.

Â That's basically what it is.

Â And this concludes this module and this course on finance for

Â non-financial professionals.

Â