Re: What's the Future Worth?
Mike,
I think Chaz did a great job of explaining the details in response to your question, so I'll try to paint the bigger picture in a different way from the norm that might make sense.
Try thinking of discounting the value of future dollars to today's present value as the collorary -- an opposite corollary -- of inflating the value of today's dollars to tomorrow's future value.
Inflation is easiest to relate to so we'll begin with that. If a can of beans costs $1.00 today and if inflation is 5% annually, how much will the can cost next year and the year after? It will cost $1.05 next year and $1.10 two years from now.
The corollary is exactly the opposite: If I know a can of beans will cost $1.05 next year and $1.10 the year after, and if I know inflation will be 5% annually, how much money do I need to set aside today invested with the same returns as the inflation rate to be able to buy the can each of the next two years? I'll need to set aside $1.00 for each can.
In fancy financial terms, I need to do that because discounting $1.10 at a 5% rate for two years results in a present value of $1.00. That's one can. Similarly, discounting $1.05 at the same rate for just one year results in a present value again of $1.00.
To put all that a little differently to get the point across:
Inflation sez that $1.00 in my pocket today invested at the inflation rate of 5% annually will be worth $1.05 a year from now. The corollary is that discounting sez that instead of having $1.05 in my pocket a year from now I'm just as well off having only $1.00 in it today and investing it in a vehicle that gives me 5% returns.
To relate that to investing, we do our best to determine two things -- what the future cash flow will be and when it will occur. That's no different from the two cans of beans. We determined what each would be worth and when.
After doing our best guestimate of those two factors, we discount those values from their respective points in time to determine what we think that future value is worth today. We call today's value the present value.
We buy a company's stock for no more than the company's future cash flows discounted to what we believe the present value is. If we think the present value is $50 per share and the market is willing to pay only $30 for it, we think the stock is undervalued.
Chaz is right that the example of 15% is only an example, just as my scenario above using 5% as an inflation rate and discount rate is nothing more than an arbitrary example.
how does this discounted cash flow analysis theory relate to actual attempts to value one investment over another?
Assume we discount the future value of Company A's cash flow and arrive at a present value of $100 million. Using the same discount rate, we do the same for Company B and determine the present value of its future cash flows is only $50 million. Investors certainly wouldn't want to pay as much for Company B as Company A.
Where I disagree with Chaz is on the following point he makes:
15% is purely a random number, but it you consider the cost of taxes, what you might earn with bonds, or with risker commercial bonds, then a reward of at least 15% begins to make sense as a minimum a stock purchaser ought to expect.
There are a lot of benchmarks an investor can use to determine the least reward we should expect from an investment in common stock. I tend to think of 10% as the least because that's about the average return of the broad stock market over many, many decades. Some people determine the current return of a 30-year bond issued by the U. S. government, being completely risk-free, and add a premium that "pays" the investor the reward for taking on the added risk of buying stock. In the context that Chaz presented it, each of us has to decide for ourselves what that premium is. (I don't mean to get in a huge discussion about that because it really is a personal decision. I brought it up only because Chaz started it. Neener neener. :)
Hope this helps. If not, try me again.
--Mike Buckley |
