Before I dive into discounted cash flow, I think it is important to go through a little overview of the DCF model. A discounted cash flow model is a way of calculating the intrinsic value of a company. By using a DCF, investors and investment bankers can try to estimate the fair market value of a company. However, DCF’s are not just for investors, they can be used by individuals within a company to determine if a new product or new branch of their business is worth pursuing. A DCF model finds the fair market value of a company by predicting its future returns and seeing if that is worth buying into the company today. For example, Company X has a 25 billion dollar market cap, but our DCF model finds that the true market cap should be 32 billion dollars, we can make the assumption that the company is currently undervalued. This signals that investors are currently paying a discount for Company X and that the market has not accounted for the potential gains of the company. Another way of approaching this would be stating that Company X’s cash flows in the future will be better than what the company is expected to have. The stock market and many areas in finance are always forward looking.

The DCF takes EBITA and divides it by the first principle of finance, the time value of money. This is an incredibly important part of the formula. The time value of money can generally be calculated by using the interest rates of the 2 year or 10 year treasury note at the time. This is why interest rates are so heavily watched by investors and companies. When interest rates are high, the time value of money is high, meaning that a project that will make 100 billion dollars when interest rates are 2% is more profitable and lucrative than if that same project is started when interest rates are at 5%. This is exactly why the Fed reduced interest rates to an artificially low level during the pandemic. With interest rates being so low, it incentivizes companies to take on new projects, which require resources and manpower. This will stimulate the economy and get it moving again. (Boy, did that work!)

While this is the general gist of the time value of money, it is not always that simple. You cannot always expect to assume the time value of money will match 1to 1 with interest rates at the time, especially for smaller companies. Introducing the acronym WACC, which stands for a company’s “weighted average cost of capital” If a company believes that a project will take 7 years, then they will calculate their WACC for those 7 years. Then by using predictions of what they think the company will make off the project, they then will divide it by the WACC. With this answer, they can figure out if the project is worth starting. In layman's terms, the WACC is the minimum threshold or (hurdle rate) that needs to be passed by the profits of said project for it to be worthwhile. In an equation it will look like this: WACC < Profits Generated by Project X. The WACC of companies will vary greatly even if they are in the same industry and have to be calculated by individually. The WACC is company specific. Smaller companies with a lesser reputation, will need to pay more in interest because they do not have the reputation of a larger company. Larger companies have built up their reputation of being successful and being able to consistently pay their investors and debts. This perfectly sums up 2 more principles of finance. These two principles are that reputation matters and high risk will generally mean higher rewards, while lower risk will mean lower reward. Let's use an example. Apple has an incredible reputation and the cost of acquiring capital will be very low. Apple has a reputation of constantly being able to pay off its debts and is arguably the most successful company in the world. Low risk for creditors lending money, but also low rewards as they will offer low interest rates. On the flip side, a company with little reputation, Rivian per se, will be much more profitable for investors lending their money. This higher profit comes with higher risk as they may never see their money return home. Therefore, they may be able to charge high interest rates, but will have to live with the thought that their money may be massacred by trying to dethrone companies (cough, cough… Tesla) whom they cannot even dream about competing with as they are already developing an electric truck. (with superior technology) May I also just mention that Rivian has recently filed for an IPO valuing the company at over 50 billion dollars even though they haven't delivered a single vehicle. Before I go on a Tesla bull rant let's move on to the conclusion shall we?

Anyways, DCF’s are popular in the investment banking and private equity field because they are a great way to value companies that are private. DCF’s are also an extremely important financial model that can tell investors, big and small, if they are paying too much for a stock, or if they just potentially found an undervalued company poised to break out. A discounted cash flow model is the marquee way of assigning a value to a company and I will be attempting to perform one every week. Enjoy!

*information used from https://www.investopedia.com