Discounted Cash Flow (DCF) Basics | Part 1 w/ Kevin Marcaida

Auto-generated video transcript:

Hello and welcome to this five part series on the discounted cash flow analysis. My name is Kevin Marcaida. I’m the lead analyst at Chinese Alpha, and as part of this mini video series, we’re going to be breaking it down. I’m going to be making the slides as interesting as engaging as possible can add a little bit of memes here and there. The primary purpose of this is so that education becomes fun.

I really hope you enjoy this five part series. So what exactly is a DCF? So a DCF is a discounted cash flow model, and it’s used to value a company based on forecasted cash flow assumptions. And again, the key word here being assumptions. At the end of the day, these aren’t scientific numbers.

These come from assumptions that we make about a company. And a DCF is used by investors, it can be used by management, and it enables us to understand the relationships of the operations of a business, how a business is positioned in terms of how many products it has, and how this relates to its financial statements, especially its cash flows, in order to make data driven decisions. Now, the DCF has a number of assumptions, but I’m going to break it down to two of its main assumptions. The first assumption is that the DCF, in order for you to use it, you have to make the assumptions that markets are temporarily inefficient and they make mistakes in assessing the value of a stock. Now, if a market was truly efficient, an efficient market means that the value of a stock and the price of a stock are always the same.

Then why bother using a DCF if you’re going to try and look for undervalued investments? And these inefficiencies actually occur because of a lack of information? This can be seen in small to mid cap companies where you don’t get as many press releases, you don’t get as many analysts covering it. It can also be due to the complexity of information. So information in a more technical field, for instance, in a bio Pharma company or in a pharmaceutical company, it can be very difficult to interpret information and how this relates to the business performance.

And because of this, it makes it very difficult for us to assess the price. And therefore, there’s a big difference between the price and the true value, the intrinsic value of a stock. And lastly, it could be due to a misinterpretation of information. It can be because these inefficiencies occur because we overreact to certain news, some news are positive we overreact to it, or it could be a deliberate misinterpretation, it could be a misinterpretation in order to manipulate information. But more on that later.

And the second assumption is that in the long term, these inefficiencies will get corrected over time. And the reason to why these inefficiencies get corrected over time is because more information becomes available to make investment decisions. So money is money but why do we discount it? What’s the point? Isn’t $100.02 years from now the same as $100 now?

Well, the truth is not really because there’s a psychological phenomenon called temporal discounting. And this is something quite relevant to me because I studied neuroscience. And essentially, this is a psychological phenomenon which refers to an individual’s tendency to perceive certain cash flows now more valuable than certain rewards later. So if I were to give you £10 right now on spot over £10.02 years down the line, you’re obviously going to take the ten pound now because one, there’s a level of certainty to that ten pound, I might not be there two years from now. So therefore, there’s a time value of money, as I’d like to say.

And this idea of temporal discounting is actually intertwined in human psychology. It’s actually very present in addiction disorders. So addicts tend to prefer a quick high right now over long term tangible results later. And the same happens in finance. We prefer cash flows now.

So if the business was generating cash flows a year or two years from now, that business is going to have more value than a business that’s going to generate future cash flows in ten years time, that is what it is. So what are the advantages of the DCF valuation? So essentially, the DCF valuation is based upon business fundamentals. It’s not based upon your emotion or market sentiment. And therefore, you’re sheltered from all these noise coming from Jim Kramer or CNBC is purely based upon how that business is operating and how much money that business is making at the end of the day.

So it’s almost like asserting a business in a bubble, really. And this enables us to have something to hold on to and to make solid investment decisions. And secondly, a DCF forces you to think about the underlying characteristics of a firm and various assumptions that you make, and it makes you a much better investor by you understanding what drives those revenues, what drives those cogs and what drives those cash flows. At the end of the day, however, a DCF does have some disadvantages. For instance, they require inputs that ultimately come from assumptions and because of these inputs can be flawed.

And it can be flawed to a number of reasons. One is that you have noisy estimates, especially if you have a young start up company. You don’t have much historical data to work on. Therefore, your estimates into the future is going to be a lot noisier. Secondly, the data can be unfortunately manipulated.

If an analyst wants to value a company really highly because they have ties to that company or whatnot, then they’re going to make the cash flows look bigger. They’re going to make a discount rate a lot smaller. If you’re going for a divorce, for instance, you’re going to want your business to be valued less. So you’re going to make the cash flow smaller. And the discount rate a lot higher, so it is subject to manipulation, unfortunately.

And thirdly, it can be subject to psychological bias. So if an analyst where to meet the CEO of a company, you really like the CEO, you’re more inclined psychologically to give this business a high evaluation than it really should. And therefore, this affects your DCF. And lastly, there is no guarantee that anything will emerge if the stock is under or overvalued. And in 2021 and 2020, we saw the covered.

Okay? That’s not something that we can predict. That’s something that pretty much is a black Swan event. And therefore, there are no guarantees when you’re conducting a DCF or whether that price will actually eventually meet that value that you essentially found in the DCF. And lastly, it’s impossible to account for all potential assumptions.

And again, a quick meme here. You’ve got to pump those numbers up. These are rookie numbers in this bracket. So how best to use the DCF? So the DCF is designed for use and assets that derive their value from their capacity to generate cash flows in the future.

So if you were to tell me that this business is not going to make any cash flow in the future, you don’t want to know what the value is that company, the value is zero. The company has to have cash flow at some point in the future. It doesn’t have to have cash flow now. Okay? And the DCF is best used for companies which have a long time horizon.

So if you have an investment strategy with a long time horizon, it is more likely that the price will meet the value in which you found in your DCF, so long as you do it right. And also, it’s better if you are able to provide the catalyst to move that price to the value. Especially if you’re an activist investor who buy out companies, you’re more likely to provide that catalyst in order to move that price up to where you expect it to be. And last of all, the DCF is very important if you’re not easily swayed or affected by market movements. And that is incredibly important.

So essentially, this is the DCF. It consists of a growth period. Now, the growth period is dependent upon the business lifecycle where the company is. So a startup is going to have a longer growth period as long as it has sustained competitive advantages. Also, a mature company is going to have a shorter growth period.

Again, as a mature company, it’s not going to grow for a very long time. And also it depends upon the competitive advantages of a company. Now, if a company has a sustained competitive advantage, then their growth period is going to be a lot larger. And that’s why you see companies like Amazon, Facebook, even though they’re large cap companies ten years earlier. From now, it still continues to grow because it has this massive competitive advantage.

And lastly, you’ve got the terminal value. This is the value of the company either into perpetuity or until it’s acquired more on this later. Anyways, thank you so much for listening to this first part series and they’re going to be more of videos further down the line explaining the DCF in a lot more detail so please stay with us and thank you very much.