263 lines
9.4 KiB
Org Mode
263 lines
9.4 KiB
Org Mode
#+title: Section 11 | Lesson 65 - DCF (Discounted Cash Flow) Analysis
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#+HTML_HEAD: <link rel="stylesheet" type="text/css" href="../_share/media/css/org-media-sass/categories/business.css" />
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#+OPTIONS: H:6
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* Links
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- [[./../mba-main.org][TOC | Business]]
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- [[https://www.udemy.com/course/an-entire-mba-in-1-courseaward-winning-business-school-prof/learn/lecture/4317198#overview][S12:L65 course video]]
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* notes
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** take the average of three valuations
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- price / earnings
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- price / sales
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- [[#dcf][Discounted Cash Flow (DCF)]]
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- because cash flow is similar to net income for tech stocks it makes things easier [[#cashflow-diff][link 1]] [[#cashflow-diff-real][link 2]]
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- DCF is the value of all future cash flows discounted today
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* definitions
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** Discounted Cash Flow (DCF)
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:PROPERTIES:
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:CUSTOM_ID: dcf
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:END:
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*** What is DCF?
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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*.
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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).
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*** Formula
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#+BEGIN_SRC latex
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\text{DCF} = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t}
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#+END_SRC
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- \( CF_t \): Cash flow at time \( t \)
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- \( r \): Discount rate (e.g., 10%)
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- \( n \): Number of years or periods
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*** Example
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You're evaluating a business expected to generate the following cash flows:
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- Year 1: $100,000
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- Year 2: $110,000
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- Year 3: $120,000
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- Discount rate: 10%
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#+BEGIN_SRC latex
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\text{DCF} = \frac{100{,}000}{(1.10)^1} + \frac{110{,}000}{(1.10)^2} + \frac{120{,}000}{(1.10)^3}
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= 90{,}909 + 90{,}909 + 90{,}163 ≈ \$272{,}000
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#+END_SRC
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*** When to Use DCF
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- When valuing businesses with predictable cash flows
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- To assess investment or project viability
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- To compare multiple investment opportunities
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*** Notes
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- DCF can include a *terminal value* if the business continues beyond the forecast period
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- Highly sensitive to discount rate and cash flow assumptions
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** Difference Between Cash Flow and Net Income
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:PROPERTIES:
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:CUSTOM_ID: cashflow-diff
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:END:
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The difference between cash flow and net income lies in *timing* and *accounting method* — they measure different things.
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*** ✅ Net Income
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The company’s *profit* after all revenues and expenses are accounted for, based on accrual accounting.
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- Appears on the income statement
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- Includes non-cash items like depreciation and amortization
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- Includes revenues earned and expenses incurred, even if no cash has changed hands yet
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- Formula:
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#+BEGIN_SRC text
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Net Income = Revenue - Expenses (including non-cash and interest/taxes)
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#+END_SRC
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*** ✅ Cash Flow
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The *actual cash* moving into and out of the business during a period.
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- Appears on the cash flow statement
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- Based on cash accounting
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- Only counts real money in/out, regardless of when it was earned or incurred
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- Includes operations, investing, and financing activities
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- Formula (Operating Cash Flow):
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#+BEGIN_SRC text
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Cash Flow from Ops = Net Income
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+ Non-cash expenses (e.g. depreciation)
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- Changes in working capital
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#+END_SRC
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*** 🧠 Key Differences
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| Feature | Net Income | Cash Flow |
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|---------------------------------+---------------------------+----------------------------------|
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| Basis | Accrual accounting | Cash accounting |
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| Includes non-cash? | Yes (depreciation, etc.) | No |
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| Timing of transactions | Matches earnings period | Based on actual cash movement |
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| Found on | Income statement | Cash flow statement |
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| Reflects profitability? | Yes | No, it reflects liquidity |
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| Negative while other is positive?| Yes | Yes — e.g., due to non-cash charges |
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*** 🔍 Example
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- A company sells $10,000 of goods but hasn’t been paid yet.
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- Net Income: Shows the $10,000 as revenue.
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** Is net income more similar to cash flow in terms of a tech stock?
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:PROPERTIES:
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:CUSTOM_ID: cashflow-diff-real
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:END:
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That is, do we effectively consider it the same when doing evaluations for tech stocks as opposed to other industries?
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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.
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*** ✅ Tech Stocks Often Emphasize Free Cash Flow (FCF) More Than Net Income
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Why?
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- Tech companies (especially SaaS) tend to have:
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- High non-cash expenses (like stock-based compensation and depreciation of capitalized R&D)
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- Deferred revenue (prepaid subscriptions)
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- Low capital expenditure needs
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These factors can cause net income to look worse than actual cash performance.
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So analysts often disregard net income in favor of:
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- Operating cash flow
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- Free cash flow (FCF):
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#+BEGIN_SRC latex
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\text{FCF} = \text{Operating Cash Flow} - \text{CapEx}
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#+END_SRC
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*** 📊 Example: Tech Company X
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| Metric | Value |
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|---------------------------+---------------|
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| Net income | $5 million |
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| Stock-based compensation | $10 million |
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| Depreciation | $3 million |
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| CapEx [[#capex][(link)]] | $2 million |
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| Operating cash flow | $18 million |
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| Free cash flow | $16 million |
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➡️ The net income looks modest, but the free cash flow is much stronger — this is what investors in tech tend to value more.
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*** 🔁 Compare with Other Industries
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| Industry | Preferred Metric | Why |
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|--------------+----------------------------+----------------------------------------|
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| Tech (SaaS) | Free Cash Flow | Low cape, high non-cash costs |
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| Utilities | Net Income + Dividends | Stable earnings, regulated cash flow |
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| Oil & Gas | EBITDA / FCF | High depreciation, volatile capex |
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| Banks | Net Income (GAAP adjusted) | Highly regulated balance sheets |
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*** 🧠 Conclusion
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- No, net income ≠ cash flow for tech stocks
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- In fact, net income may understate performance due to:
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- High non-cash expenses (e.g., stock comp)
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- Accounting rules around R&D and subscriptions
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- DCF models for tech should focus on FCF or adjusted EBITDA, not just net income - Cash Flow: $0 until cash is actually received.
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** CapEx – Capital Expenditures
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:PROPERTIES:
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:CUSTOM_ID: capex
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:END:
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*** What is CapEx?
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CapEx stands for *Capital Expenditures* — it refers to money a company spends to acquire, upgrade, or maintain physical assets such as:
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- Equipment
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- Buildings
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- Vehicles
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- Technology infrastructure
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- Property
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*** In Plain Terms
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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.
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*** Accounting Treatment
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- CapEx is not expensed all at once on the income statement.
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- It’s capitalized — added to the balance sheet as an asset — and then depreciated over time.
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*** Examples
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| Action | CapEx? |
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|-----------------------+----------------|
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| Buying servers | ✅ Yes |
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| Repainting the office | ❌ No (OpEx) |
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| Building a data center| ✅ Yes |
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| Paying engineers | ❌ No (OpEx) |
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*** CapEx in Valuation
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- Important in Free Cash Flow (FCF) calculations:
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#+BEGIN_SRC latex
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\text{FCF} = \text{Operating Cash Flow} - \text{CapEx}
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#+END_SRC
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- High-growth tech companies often have low CapEx, which boosts FCF and valuation.
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- Asset-heavy companies (like telecom, energy, or manufacturing) have high CapEx, reducing FCF.
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** EBITDA - Earnings Before Interest, Taxes, Depreciation, and Amortization
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*** What is EBITDA?
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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.
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*** Purpose
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EBITDA is commonly used to:
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- Assess a company’s operating performance
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- Compare companies across industries
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- Approximate cash flow (roughly)
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*** Formula
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From Net Income:
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#+BEGIN_SRC text
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EBITDA = Net Income
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+ Interest
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+ Taxes
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+ Depreciation
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+ Amortization
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#+END_SRC
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From Operating Income (EBIT):
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#+BEGIN_SRC text
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EBITDA = Operating Income
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+ Depreciation
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+ Amortization
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#+END_SRC
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*** Why Use EBITDA?
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| Benefit | Explanation |
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|--------------------------+----------------------------------------------------|
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| Strip out accounting noise | Removes non-cash charges like depreciation |
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| Cross-industry comparison | Ignores capital structure and tax regime effects |
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| Cash flow proxy | Gives a rough estimate of operating cash flow |
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*** Cautions
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- EBITDA is *not* actual cash flow.
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- It ignores capital expenditures and changes in working capital.
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- It can be used to obscure poor net income performance.
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- Not suitable for asset-heavy businesses as it omits large CapEx burdens.
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*** Example
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Suppose a company reports:
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- Net Income: $1,000,000
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- Interest: $500,000
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- Taxes: $400,000
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- Depreciation: $300,000
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- Amortization: $200,000
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#+BEGIN_SRC text
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EBITDA = 1,000,000 + 500,000 + 400,000 + 300,000 + 200,000 = $2,400,000
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#+END_SRC
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