One of your friend is coming to you and asking whether you are interested in buying a cash producing tree.
If it is in fact producing cash, how much would you pay for it?
How can you evaluate its worth?
For that, you can use a valuation method called, "Discount Cash Flow Model".
That will be the topic of discussion for this episode.
If you know this valuation method, you can valuate any business or stock or any asset with cash flow.
This is not going to give you an accurate valuation.
But at least it will give you some idea on valuation rather than left in the dark.
If we are going to talk about valuation, it is automatically implied that we are going to talk lot of Math.
If you are allergic to Math calculations, feel free to stop here and save yourself some time.
For the rest, Hi, My name is Vijay Mohan and you are watching - Investment Insights.
We should know the cashflow of this cash producing tree to evaluate it.
Your friend who is trying to sell this tree to you is saying that this tree can produce a cash of around Rs.1 Lakh per year on average.
He is also saying that this tree will live at least for another 25 years.
Let's put 1 Lakh as future cash flow for next 25 years.
When we add u the total cash flow, we get Rs.25 Lakhs.
That means the value of the tree is, Rs.25 lakhs.
"Wait a minute... I already have Rs.25 lakhs in my hand.
"Why should I give that money to someone to give the same 25 lakhs in 25 years?
"Wouldn't that be a loss for me?
"I could have invested that money somewhere else which can grow every year.
"If I buy this tree with that money, then I am losing the opportunity".
You are right. The opportunity cost of Rs.25 lakhs would be a loss for you.
Then you cannot give Rs.25 lakhs for this tree for sure.
For the opportunity cost loss, you should definitely get a discount in the price.
How much discount could that be?
That depends on what would you have done with the Rs.25 lakhs.
You could have saved the money in a Fixed Deposit for 7% interest.
Then in that case, your discount rate is 7%.
We should apply this 7% discount in every year's cash flow.
We cannot apply this discount just like that.
This discount compounds every year.
This discount factor column shows how it is compounding every year.
First year discount factor is 0.93.
We will see how we arrived at this 0.93 few minutes later.
93% or so of Rs.1 lakh is what we are seeing as Rs.93,458 in present value column.
This means, if Rs.93,458 has grown by 7%, it would have become Rs.1 lakh.
Second year discount factor is 0.87.
That means, the present value of Rs.1 lakh cash flow in the second year is Rs.87,344.
All these numbers we are seeing here is very similar to compounding calculation, just that we are seeing them in reverse order.
If this Rs.81,830 has grown by 7% per year for 2 years, then it would have become Rs.1 lakh.
It is same for the third year value of Rs.81,630.
If this has grown by 7% per year for 3 years, it would have become Rs.1 lakh.
The present value we see here is, today's value of Rs.1 lakh that will be produced 3 years later.
This present value calculation is the very first topic in every financial class.
Present value = Future value divided by, (1+interest rate) to the power of number of years.
So the present value of 1 lakh that we are going to get in 3 years is, 1 lakh/(1+7%)^3.
That will be Rs.81,630. That is exactly what we are seeing in the spreadsheet.
So the discount factor is part of present value formula. 1/(1+discount rate)^n.
For 7% discount rate, the discount factor for first year is 0.93.
For second year, it is 0.87 and so on.
When we look the discount factor values from bottoms up, we can see that it is increasing by 7% every year.
Using this discount factor, we are calculating the present value of each Rs.1 lakh cash flow every year.
If we add all the present values for 25 years, we can find the value of the cash producing tree.
It is Rs.11,65,000.
So can we buy the tree for Rs.11,65,000?
Wait. The interest rate we used was risk free fixed deposit rate.
Is this tree risk free as well?
We cannot say that. It can die, can be brought down by storm, can be infested by bugs - many risks are there.
So how can we compensate for the additional risk?
We have to increase the discount factor by the amount of additional risk.
Let's say that this tree has same risk as equity market.
Then in that case, we have to use the long term equity market return 12% as discount rate here.
Now the value of the tree comes down to Rs.7,84,000.
See how many assumptions we have made in calculating the value of a cash producing tree?
That is why valuation is very personal.
You don't have to assume what I am assuming.
So your valuation could be totally different from mine.
But still, we can use this as a rough guidance.
In this example, we are assuming that this tree will live for next 25 years.
But in a typical business, we will not be able to project its cash flow for 25 years.
Lot of things change in 25 years.
So it is better to project the cash flow for next 5 years.
After 5 years, we can come up with a terminal value for the business depending on its value at that time and use that to find its value Today.
Similarly, we cannot assume a constant cash flow of 1 lakh like here in a business.
In a good business, the free cash flow from profit should go up every year.
We should know its growth rate.
We should increase the cash flow every year based on its growth rate.
Let's calculate the terminal value first for our example.
How can we do that? We should use Gordon Growth Model formula.
Final year cash flow * (1+perpetuity growth rate)/(Discount rate - perpetuity growth rate).
Perpetuity growth rate is the growth rate of the business after 5 years.
Let's assume that the growth rate and perpetuity growth rate is 0%.
Then the terminal value is Rs.8,33,000.
We are calculating the present value of terminal value using the same 5th year discount factor.
It is Rs.4,72,000.
Now the value of the tree is, Rs.8,33,000.
Did you notice that the terminal value we calculated after 5 years is this same Rs.8,33,000?
That is because our example does not have growth rate. Constant cash flow.
Let's say that out tree is growing 10% every year like a growth company.
Then the growth rate is 10%.
We can see the future cash flow increasing 10% every year here.
The tree will mature completely after 5 years.
After 5 years, it grows 5% every year.
Then the perpetuity growth rate is 5%.
Now the terminal value is almost Rs.22 lakhs.
The present value of that terminal value is Rs.12,46,000.
So the Today's value of this tree is, Rs.16,76,000.
This is how we should valuate a business based on its future cash flow.
This is not an accurate valuation.
But this will give you a rough idea about the valuation.
Shall we valuate Nvidia using this discount cash flow?
Nvidia's last quarter net profit is $9.2 Billion.
Then the cash flow for one year will be, 4 times 9 billion, $36 billion.
Let's use the same discount rate of 12%.
Growth rate - Nvidia's revenue in Q3 2023 is $6 billion.
Now in Q3 2024, the revenue has gone up to $18 Billion.
200% growth. This has come from recent AI boom.
We cannot expect this 200% growth in coming years. But can we expect a 30% growth? That would be reasonable I think.
Let's say that its growth slows down after 5 years to 5%.
How much value can we give to Nvidia for these valuations?
DCF model is saying that we can give $1.4 trillion.
Today in the market, Nvidia has a valuation of $1.17 Trillion.
So market is not far off and is very reasonable in its valuation.
These are all assumptions on future cash flow numbers.
When these assumptions turn not true, the valuation will totally change.
Something to remember.
I will meet you soon in another episode. Bye.