As an investor, your first question should be: “How much money do I get back — and when?” To answer this question, you often need to perform a DCF calculation (Discounted Cash Flow). This entails calculating the present value of future cash flows – and what they would be worth if received immediately, rather than waiting for the project to unfold over many years.

The DCF discount rate

To perform a DCF you requires an estimate of the Discount Rate.

The discount rate is the variable used to calculate the present value from future cash flows.

Choosing a discount rate can be challenging as there are various methods to consider. The easiest is to use your nearest opportunity cost.

Simplest example:

The simplest type of project involves lending out 100 SEK in exchange for receiving 110 SEK in one year. It’s worth 110 – 100 = 10 SEK, assuming no time cost and perfect certainty.

With an opportunity cost of 10% per year, the project’s value becomes 0 SEK, since today’s outflow is worth -100 SEK and the inflow of 110 SEK in one year is worth 110/1.1 = +100 SEK.

More complex examples?

When analyzing larger companies (such as public corporations), it becomes more complicated. Often, you need to examine their cash flow statements from the annual report.

More about the Discount Rate:

The discount rate is pivotal in calculating future cash flows.

The calculation looks like this:

NPV = F / (1 + i)^n

• NPV = Discounted present value of future cash flows
• F = Future cash flows
• i = Discount rate
• n = Number of years

Without a realistic discount rate, you may obtain weird results. Hence, it’s crucial to use a discount rate that you comprehend and feel comfortable with.

Choosing a discount rate involves many methods, making it a complex subject.

The easiest way to choose a discount rate is by setting your own nearest opportunity cost. In other words: what else you could have done with your capital during this time – and how rapidly your alternative would have made the money grow.

Here are the most common examples of people’s opportunity costs:

• Interest on a bank account
• Bond yield
• Dividend on your best security
• Growth rate on your best security

Three additional examples:

• Lending money to people at a specific rate
• Your earning potential on your own project (e.g., consultant or entrepreneur)
• Your own company’s profitability

You can also inquire what discount rate other investors use or contact your brokerage firm.

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The difference between the income statement and cash flow is that cash flow represents the actual cash, whereas the income statement is a narrative of profitability.

Keep it simple, DCF’s are dangerous

When examining a company’s financial reports to gauge its future value, keep it as simple as possible:

Forecast just one line at a time.

This is my preferred process: Make reasonable assumptions for one variable at a time about (1) growth, (2) margins, and (3) investment needs, given what you know about historical trends, the company’s official objectives and forecasts (“guidance”), and external events, competitive situation, and the general economy.

Common Question: “How far back should I look when examining financial reports? How much data do I need to go through to understand enough?”

Short Answer: Go back as many years as the company’s operation/business model has remained the same.

Longer Answer: Consider how much data in depth (number of years) and breadth (number of variables) you actually need. If the company has been about the same for ten years as it is today (growth rate, approximate size vs the economy, margins, return on equity, competitive situation etc), you can assume it continues in the same fashion. Regarding forecasts for many years into the future, consider whether adding more years is actually adding information, rather than meaningless guesses and noise (forecasts far into the future become increasingly uncertain and meaningless).

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You May Also Want to Read:

• When is a Stock Cheap?
• What is Intrinsic Value?
• Inversion: Instead of DCF – Calculate the future price and think backwards