#+title: Section 11 | Lesson 65 - DCF (Discounted Cash Flow) Analysis #+HTML_HEAD: #+OPTIONS: H:6 * 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][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 * 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