#+title: Section 11 | Lesson 65 - DCF (Discounted Cash Flow) Analysis
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* Links
- [[./../mba-main.org][TOC | Business]]
- [[https://www.udemy.com/course/an-entire-mba-in-1-courseaward-winning-business-school-prof/learn/lecture/4317198#overview][S12:L65 course video]]


* notes
** take the average of three valuations
- price / earnings
- price / sales
- DCF
** [[#dcf][Discounted Cash Flow (DCF)]]
  - because cash flow is similar to net income for tech stocks it makes things easier [[#cashflow-diff][link 1]] [[#cashflow-diff-real][link 2]]

  - DCF is the value of all future cash flows discounted today
*** how we do it
- assume we are going public in 2020
- need to look at cash flow for 2020-2025
- calculate WACC (cost of capital)
- calculate beta from the internet
  - three companies similar to ours
  - average it out

*** formulas
****  weighted average cost of capital
  - \( \text{WACC} = \text{Cost of Equity} + \text{Cost of Debt} \)

  - we subtract debt b/c it's a hi tech company

**** Cost of Equity Formula

\( \text{Cost of Equity} = r_f + (r_m - r_f) \cdot \beta \)

Where:
- \( r_f \) = Risk-free rate (government rate)
  - theoretical rate of return on an investment with zero risk
  - how much an investior would expect on a completely safe investment over a given time period
  - usually based on yield of government bonds
- \( r_m \) = Stock market return
  - expected or historical average annual return of a broad stock market index
    - S&P 500
    - TA-125
    - MSCI World Index
  - annual return (%) expected from the overall stock market
- \( \beta \) = Volatility (beta) of the company
  - finanicial websites that list ϐ (beta)
    - yahoo finance -> search for a stock -> under statistics -> see Beta
    - google finance, morningstar, marketwatch

  - beta measures how much a stock moves relative to the market
    - you can calculate it

* definitions
** Discounted Cash Flow (DCF)
:PROPERTIES:
:CUSTOM_ID: dcf
:END:

*** What is DCF?
Discounted Cash Flow (DCF) is a financial valuation method used to estimate the *present value* of an investment or business based on its *expected future cash flows*.

The core idea: *money today is worth more than money tomorrow*, due to the time value of money. DCF discounts future expected cash flows back to their present value using a discount rate (usually the cost of capital).

*** Formula
#+BEGIN_SRC latex
\text{DCF} = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t}
#+END_SRC

- \( CF_t \): Cash flow at time \( t \)
- \( r \): Discount rate (e.g., 10%)
- \( n \): Number of years or periods

*** Example
You're evaluating a business expected to generate the following cash flows:

- Year 1: $100,000
- Year 2: $110,000
- Year 3: $120,000
- Discount rate: 10%

#+BEGIN_SRC latex
\text{DCF} = \frac{100{,}000}{(1.10)^1} + \frac{110{,}000}{(1.10)^2} + \frac{120{,}000}{(1.10)^3}
= 90{,}909 + 90{,}909 + 90{,}163 ≈ \$272{,}000
#+END_SRC

*** When to Use DCF
- When valuing businesses with predictable cash flows
- To assess investment or project viability
- To compare multiple investment opportunities

*** Notes
- DCF can include a *terminal value* if the business continues beyond the forecast period
- Highly sensitive to discount rate and cash flow assumptions

** Difference Between Cash Flow and Net Income
:PROPERTIES:
:CUSTOM_ID: cashflow-diff
:END:

The difference between cash flow and net income lies in *timing* and *accounting method* — they measure different things.

*** ✅ Net Income
The company’s *profit* after all revenues and expenses are accounted for, based on accrual accounting.

- Appears on the income statement
- Includes non-cash items like depreciation and amortization
- Includes revenues earned and expenses incurred, even if no cash has changed hands yet
- Formula:

#+BEGIN_SRC text
Net Income = Revenue - Expenses (including non-cash and interest/taxes)
#+END_SRC

*** ✅ Cash Flow
The *actual cash* moving into and out of the business during a period.

- Appears on the cash flow statement
- Based on cash accounting
- Only counts real money in/out, regardless of when it was earned or incurred
- Includes operations, investing, and financing activities
- Formula (Operating Cash Flow):

#+BEGIN_SRC text
Cash Flow from Ops = Net Income
                   + Non-cash expenses (e.g. depreciation)
                   - Changes in working capital
#+END_SRC

*** 🧠 Key Differences

| Feature                         | Net Income               | Cash Flow                       |
|---------------------------------+---------------------------+----------------------------------|
| Basis                           | Accrual accounting        | Cash accounting                 |
| Includes non-cash?              | Yes (depreciation, etc.)  | No                              |
| Timing of transactions          | Matches earnings period   | Based on actual cash movement   |
| Found on                        | Income statement          | Cash flow statement             |
| Reflects profitability?         | Yes                       | No, it reflects liquidity       |
| Negative while other is positive?| Yes                      | Yes — e.g., due to non-cash charges |

*** 🔍 Example
- A company sells $10,000 of goods but hasn’t been paid yet.
  - Net Income: Shows the $10,000 as revenue.

** Is net income more similar to cash flow in terms of a tech stock?
:PROPERTIES:
:CUSTOM_ID: cashflow-diff-real
:END:

That is, do we effectively consider it the same when doing evaluations for tech stocks as opposed to other industries?

Great question — and the answer is *no*, net income is not considered equivalent to cash flow, even for tech stocks — though the relationship can be closer or more misleading depending on the business model.

*** ✅ Tech Stocks Often Emphasize Free Cash Flow (FCF) More Than Net Income

Why?

- Tech companies (especially SaaS) tend to have:
  - High non-cash expenses (like stock-based compensation and depreciation of capitalized R&D)
  - Deferred revenue (prepaid subscriptions)
  - Low capital expenditure needs

These factors can cause net income to look worse than actual cash performance.

So analysts often disregard net income in favor of:

- Operating cash flow
- Free cash flow (FCF):

#+BEGIN_SRC latex
\text{FCF} = \text{Operating Cash Flow} - \text{CapEx}
#+END_SRC

*** 📊 Example: Tech Company X

| Metric                    | Value         |
|---------------------------+---------------|
| Net income                | $5 million    |
| Stock-based compensation  | $10 million   |
| Depreciation              | $3 million    |
| CapEx [[#capex][(link)]] | $2 million    |
| Operating cash flow       | $18 million   |
| Free cash flow            | $16 million   |

➡️ The net income looks modest, but the free cash flow is much stronger — this is what investors in tech tend to value more.

*** 🔁 Compare with Other Industries

| Industry     | Preferred Metric           | Why                                    |
|--------------+----------------------------+----------------------------------------|
| Tech (SaaS)  | Free Cash Flow             | Low cape, high non-cash costs          |
| Utilities    | Net Income + Dividends     | Stable earnings, regulated cash flow   |
| Oil & Gas    | EBITDA / FCF               | High depreciation, volatile capex      |
| Banks        | Net Income (GAAP adjusted) | Highly regulated balance sheets        |

*** 🧠 Conclusion

- No, net income ≠ cash flow for tech stocks
- In fact, net income may understate performance due to:
  - High non-cash expenses (e.g., stock comp)
  - Accounting rules around R&D and subscriptions
- DCF models for tech should focus on FCF or adjusted EBITDA, not just net income - Cash Flow: $0 until cash is actually received.

** CapEx – Capital Expenditures
:PROPERTIES:
:CUSTOM_ID: capex
:END:

*** What is CapEx?
CapEx stands for *Capital Expenditures* — it refers to money a company spends to acquire, upgrade, or maintain physical assets such as:

- Equipment
- Buildings
- Vehicles
- Technology infrastructure
- Property

*** In Plain Terms
CapEx is money spent on things that last more than one year — unlike operating expenses (OpEx), which are day-to-day costs like rent, salaries, or utilities.

*** Accounting Treatment
- CapEx is not expensed all at once on the income statement.
- It’s capitalized — added to the balance sheet as an asset — and then depreciated over time.

*** Examples

| Action                | CapEx?         |
|-----------------------+----------------|
| Buying servers        | ✅ Yes          |
| Repainting the office | ❌ No (OpEx)    |
| Building a data center| ✅ Yes          |
| Paying engineers      | ❌ No (OpEx)    |

*** CapEx in Valuation
- Important in Free Cash Flow (FCF) calculations:

#+BEGIN_SRC latex
\text{FCF} = \text{Operating Cash Flow} - \text{CapEx}
#+END_SRC

- High-growth tech companies often have low CapEx, which boosts FCF and valuation.
- Asset-heavy companies (like telecom, energy, or manufacturing) have high CapEx, reducing FCF.

** EBITDA - Earnings Before Interest, Taxes, Depreciation, and Amortization

*** What is EBITDA?
EBITDA is a measure of a company’s core operational profitability. It strips out the effects of financing decisions, tax environments, and non-cash accounting items like depreciation and amortization.

*** Purpose
EBITDA is commonly used to:
- Assess a company’s operating performance
- Compare companies across industries
- Approximate cash flow (roughly)

*** Formula

From Net Income:
#+BEGIN_SRC text
EBITDA = Net Income
       + Interest
       + Taxes
       + Depreciation
       + Amortization
#+END_SRC

From Operating Income (EBIT):
#+BEGIN_SRC text
EBITDA = Operating Income
       + Depreciation
       + Amortization
#+END_SRC

*** Why Use EBITDA?

| Benefit                  | Explanation                                        |
|--------------------------+----------------------------------------------------|
| Strip out accounting noise | Removes non-cash charges like depreciation       |
| Cross-industry comparison | Ignores capital structure and tax regime effects |
| Cash flow proxy           | Gives a rough estimate of operating cash flow    |

*** Cautions
- EBITDA is *not* actual cash flow.
- It ignores capital expenditures and changes in working capital.
- It can be used to obscure poor net income performance.
- Not suitable for asset-heavy businesses as it omits large CapEx burdens.

*** Example
Suppose a company reports:

- Net Income: $1,000,000
- Interest: $500,000
- Taxes: $400,000
- Depreciation: $300,000
- Amortization: $200,000

#+BEGIN_SRC text
EBITDA = 1,000,000 + 500,000 + 400,000 + 300,000 + 200,000 = $2,400,000
#+END_SRC
