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Section 11 | Lesson 65 - DCF (Discounted Cash Flow) Analysis
- Links
- notes
- definitions
notes
take the average of three valuations
- price / earnings
- price / sales
definitions
Discounted Cash Flow (DCF)
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
\text{DCF} = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t}- \( CF_t \): 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%
\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{,}000When 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
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:
Net Income = Revenue - Expenses (including non-cash and interest/taxes)✅ 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):
Cash Flow from Ops = Net Income
+ Non-cash expenses (e.g. depreciation)
- Changes in working capital🧠 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?
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):
\text{FCF} = \text{Operating Cash Flow} - \text{CapEx}📊 Example: Tech Company X
| Metric | Value |
|---|---|
| Net income | $5 million |
| Stock-based compensation | $10 million |
| Depreciation | $3 million |
| 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
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:
\text{FCF} = \text{Operating Cash Flow} - \text{CapEx}- 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:
EBITDA = Net Income
+ Interest
+ Taxes
+ Depreciation
+ AmortizationFrom Operating Income (EBIT):
EBITDA = Operating Income
+ Depreciation
+ AmortizationWhy 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
EBITDA = 1,000,000 + 500,000 + 400,000 + 300,000 + 200,000 = $2,400,000