# Discounting – the ‘D’ in DCF valuations.

There is a saying that the most powerful force in the universe is love, and that compound interest is the 2nd most powerful. Based on personal experience, I’d agree with both.

It’s time to cover Discounting – the ‘D’ in DCF valuations. Discounting cash flows that we expect in future back to their present value today is just running compounding in reverse. Many people struggle with the concept of the time value of money, so it’s worth spending a little effort here getting the basics in place.

What we’re trying to do is estimate returns. Returns from a business investment come from 2 places – from dividends paid out of profits over the life of the investment, and from the difference between the price you sell for and the price you paid (hopefully a capital gain). Since smaller businesses typically re-invest almost all of their dividends to fund their growth, we expect most of our Return on Investment (ROI) to come from capital gain.

If I buy a business for R1M today and sell if for R1.5M in year’s time, my return has been an easy 50%. If it also paid me dividends of R50K in that year then my return is actually 55%. If it cost me R150K of consulting and legal fees to buy the business and then sell it again, then my net return has been R400K or 40%. However inflation at 5% means my purchasing power has eroded by R70K over the year and my real return is 33%. The lesson here is that transaction fees (the consulting & brokerage charges) and inflation can destroy your investment returns. Transaction costs in the SMB are very high- I’ve seen research suggestion 25% of the deal (when you add it all up) in some cases.

The formula for calculating the future value of an investment that compounds its returns over time is as follows: FV=PV*(1+R)^N

FV=Future Value, PV=Present Value, R=% return per compounding period, and

N=number of periods (there is a big difference between interest compounded daily/monthly/annually – so this is NB to match the interest rate to the period)

So a R1M investment that gives a 10% annual return over 10 years would be worth R2.59M. FV=1*(1+10%)^10=2.59M

Yet a the same capital invested at 20% gets nearly the same return in just 5 years: FV=1*(1+20%)^5=2.49M…and if held for 10 years would get R6.19M. The extra 10% interest per year makes a difference of 240% to the final amount you receive after 10 years! That’s the power of compounding – exponential maths means that small differences applied over a long time make huge differences at the end.

Now let’s turn this around and look at the discounting. Remember that our purpose here is to compare different investment choices we have, and what we want to know is what each is worth in today’s terms.

For example, the (fictional) company Madoff, Brown, & Tannenbaum offer me a deal where I invest R1M with them now and they promise me a R10M return in 10 years. How do I calculate what that R10M is actually worth in today’s money? It depends on the risk, as we’ll soon see.

Here is the compounding formula, turned around to make it into a discounting formula: PV=FV/(1+R)^N

Here R becomes the discount rate. Discount rate measures risk, which you can think of as the expected variance in return: the more you expect actual returns might vary from what is expected, the higher the discount rate you should use.

To understand the risk I chat to the Mr Tannenbaum who assures me there’s no more than 15% risk. Using this in the formula I’d get:

PV=10M/(1+15%)^10=R2.471M

Given that I’m only putting R1M in, to get R2.5M back in today’s money seems like a great deal. However I like to achieve at least 35% return on my money, so I use a discount rate of 35%, and suddenly the Present Value of my money is only R497K – a big loss on the R1M I’d have to put in, so I choose to walk away.

What discount rate should you use? For most SMBs you’ll probably want to start around the 30-40% mark. There is substantial risk, which we’ll get into down the line.

Next week we’re going to finally do a full DCF Valuation, with plenty discussion around the variances thereon in the weeks to follow. Just in time for you to get a good feel for your business before you have a Christmas break!

# Understanding cash flow in more depth.

In this weeks article we cover some practical cash flow calculations. These will form the basis of our DCF valuation in weeks to come. Whereas in last weeks article we used a cash-flow hack to simplify the formula for small businesses, today we’ll use the full formula, which is:

Cash flow = Net Income + Depreciation – Capital expenditures – Increases in required Net Working Capital + cash received from sale of fixed assets – Gain on sale of assets + Increase in long-term debt + Sale of shares – purchases of shares – Dividends paid.

We discussed Depreciation, Capex, and Increases in Net working capital last week (and we covered Net Income in our growth forecasting a few weeks back).

Sales of fixed Assets: When you sell a fixed asset you receive cash for it. Since the sale of the asset and the cash flow from it appear on the balance sheet only (unless these are extraordinary items), they don’t appear in Net Income and so we must add the cash realised from sale back to Net Income. If we sold the item for more than we bought it for and thus made a gain, then this will have already reflected in the Income statement and in order to calculate cash flows we need to subtract it (or add it back if we made a loss on the sale).

Financing through long-term debt, share issue/purchase, and dividends: Increasing long-term debt and selling shares are sources of cash, so we add them in our formula. Conversely, when we buy back shares or pay dividends then we reduce cash and must subtract this from Net Income to get to cash flow. (Note that we’ll discuss these items in a lot more detail when we move from how to value your business to how to increase it’s value – the cash flowing from financing activities can make a radical difference to the grow rate and hence the valuation of the firm.)

You can see that if a business doesn’t sell fixed assets, or doesn’t issue long-term debt or sell shares, then the long-version of the equation becomes the hack we discussed last week.

Growing v. Stable companies: The obvious thing to watch out for is high growth companies – any company growing over 10% pa is most likely funding this growth through a combination of debt and equity transactions, and given the demands that growth places on cash flow, you’ll need to make sure you take the long-way around and do the sums properly. While the differences in a given year can seem slight, remember that a DCF valuation is all about compounding and that small differences can make a large impact to the overall value of the business.

Stable, non-growing firms illustrate the point that for them, Net Income is effectively cash flow. Why? because if they increase debt they’ll increase cash in the short-term but be saddled with interest and capital repayments which decrease cash over the long-term. Likewise, a firm that issues more shares to raise capital also dilutes the earnings per share in the long-term. In a stable environment, these payments are all met directly from Net Income.

Practical application: Firms with a high profit margin have low costs relative to sales and thus require less cash to fund the sales, which means the business can grow faster without increasing working capital proportionately. This means they’re worth more. The converse holds for low-profit margin firms…it’s worth doing everything possible to increase your margins over time – a question largely of strategy.

• If you’re a high margin firm whose creditors terms match the debtors terms, then your debtors will be higher (because of your profit margins) and you’ll need more working capital to fund them.
• If your credit policy is more lenient than your suppliers then your debtors/receivables will be higher than payables/creditors and you’ll need more working capital. As sales grow this gap will increase. Even high margin businesses who can’t get cash in fast enough will risk going out of business.
• Firms with high stock (inventory) holding have higher working capital requirements. So product based firms have higher working capital requirements than service-based firms (whose only real payable is their staff, typically paid every 2 weeks or at month end).

Next week we’re going to discuss the Discounting – the mathematical means by which we can bring a variable stream of predicted income and risk back to a single number measured in todays’ currency.

# Cash-flow hacks

Regular readers of this column will be happy to know that we’re getting closer to the meat of the much-anticipated DCF valuation. Having spent the last weeks predicting the growth in profits of the firm, today we’re going to look at how we get to cash flows (the ‘CF’ part of DCF). This article will cover the theory, with next week’s covering a practical example and an updated online model.

First, the full formula for how to calculate cash flows:

Cash flow = Net Income + Depreciation – Capital expenditures – Increases required Net Working Capital + cash received from sale of fixed assets – Gain on sale of assets + Increase in long-term debt + Sale of shares – purchases of shares – Dividends paid.

Now, here’s the entrepreneurial hack of the above that simplifies things and will be quite adequate for smaller businesses:

Cash flow = Net Income + Depreciation – Capital expenditures – Increases in Non-cash net working capital.

Working with the hacked version, let’s take each of these in turn:

Net income powers cash flow. Although you can have periods of negative net income (in which case current or fixed assets must be depleted in order to fund the business), it’s not sustainable in the long-term. Raising capital increases current assets however these will be depleted again unless Net income becomes positive.

Depreciation and Capital expenditures are really two sides of the same coin. You spend money on Capex, which is then depreciated over time. In a steady-state business with nominal growth you’d expect that these would almost cancel each other out, as Capex maintained productive capacity at the same rate as the old capacity was depreciated, however you’d be wrong: Capex will be larger than depreciation because the new machinery costs more than the old machines (due to inflation over the period). Note that this is different for companies using a lot of IT hardware, as the productive capacity typically doubles in 18 months while prices drop substantially too. In high-growth firms Capex is much higher than depreciation, since substantial investment must often be made to fuel the future growth of the business. On the other hand, a firm that is in decline will tend to have more depreciation than Capex, since little investment is being made into the future productive capacity yet the business is still incurring charges for older investments. Depreciation is a non-cash expense that is deducted from Net income. Since no cash actually changes hands we must add it back to Net Income to understand the cash flow position. Capex doesn’t appear on the Income statement yet it’s a direct cash expense, so we must remove it from the Net Income number in order to understand cash flow.

An important by-product of this relationship is that looking at the pattern of Capex v. depreciation over the past few years can often give you very quick insight into how management perceive the future of the business (and how much productive capacity remains in the firm). Quite often their pattern of investment for the future shows very different beliefs to the story they will tell you about the fantastic future ahead for the business. Be wary where Capex is not at least 5% higher than depreciation.

Increases in Non-cash Net working capital tell you a lot about how effectively the business is being run and how much growth it can sustain: as firms grow they need to increase current assets to fund that growth (increased inventory, credit terms to customers) and the cash for growth must come from somewhere and this typically includes the bank (notes payable), suppliers (accounts payable) or the companies’ own profits (their bank account). So we remove the increase in non-cash net working capital from Net income to understand cash flows in the business.

A quick example calculation of Net working capital:

Assume your customers pay you on 30 days average, and that you increase sales from R1.2M in year to R1.5M in the next. This increase in sales will lock up an extra R25K of cash in working capital. In other words, Net income for the period will overstate cash-flow by R25K, and we have to subtract that using the cash flow hack equation above. Lets say we increased our inventory (stock) levels over the same period by R50K, mainly to service the new sales growth and prevent a stock-out situation. This stock increase has costs us money and had drained cash. So we subtract the increase from Net Income to get to cash flow. However, our suppliers let us buy this stock on credit, so they are financing this. The net effect of the increase in our creditors/payables cancels out the stock increase. So we end up only reducing Net income by the R25K of increased receivables during this period.

One last, important note for this week: when dealing with balance sheet items such as those above, we only add the increase in these items to our net income line (or subtract the decrease). However we must add the full amount (i.e. not just the difference) of Depreciation expenses and subtract the full amount of Capex from Net Income.

More on that, with an update to our online model next week.

# Forecasting growth

Previously, we made some adjustments to the Income Statement of the privately owned company ‘Wobbly Machinery’ to get to a real indication of its sustainable profit margins, which we determined were approx. 11.4%. This week we’ll try to estimate what growth in profits we can expect going forward: it’s this growth that is central to the valuation of the firm.

In the DCF valuation that we are working towards, we break down growth into 2 phases: in the first phase, typically the next 3-5 years, we expect the firm to grow fastest and hopefully outpace both its competitors and inflation. In the 2nd phase, typically years 6 onwards, we expect the firm to grow more or less at inflation rates (in other words, to keep pace with the economy but add little real growth).

In the entrepreneurial environment the shortcut is to focus all our efforts on understanding how much ‘above industry’ growth is possible in the next 3 to 5 years, then assume that the firm holds pace with inflation thereafter. We need to understand by how much, and for how long, the firm can beat the market. If there is good reason for this high growth to continue for a longer period, then we can extend the high growth period in the DCF, or build a slight margin over inflation in the long term. In the very long-term however, there are very few (if any) firms that outpace inflation.

Predicting sales growth is never easy: most of the potential for a firm to experience high growth or high profits for a sustained period of time comes down to the industry structure and competitiveness. The classic tool for understanding this is the Porter 5-forces analysis (which I intend to cover in a full article on its own). The summarised version is as follows: the more competitive the industry, the lower its profit margins and the less attractive it is to investors (since it’s much harder for any one firm to generate super-returns). Industry competitiveness at the micro (as opposed to overall economy or ‘macro’) environment depends on:

• The threat of new competition
• The threat of substitute products
• Bargaining power of customers
• Bargaining power of suppliers
• Overall industry rivalry between firms.

In predicting growth you need to get a good feeling for how competitive the industry is and how this will change over time. Thinking through each of the 5 forces is a useful tool to help sharpen any debate and argue why something will grow/won’t grow.

In terms of where to get your information, there is no shortcut for research. Read industry news. Watch industry trends, set up Google Alerts. Speak to research analysts and speak to customers. Get a strong idea of why people buy the product and what else competes for that money. Look at how competitors have responded to your advertisements. Understand how they attempt to differentiate themselves in the eyes of their customers. Watch out closely for situations where any one supplier or customer accounts for more than 10% of your business and isn’t easily substitutable.

So lets put this into practice with our spreadsheet and Wobbly Machinery: we need to look at the sheet ‘Predicting Growth’ on the public model here: https://docs.google.com/spreadsheet/ccc?key=0Au_-6dIUABkTdGJ6bFpVOGhvOGQyOVpvbFkybi14MlE

We see that historic CAGR in sales has been about 7%, but management convince us that the new product launch will see 9% in the next year. We’re not convinced so much thereafter, and gradually expect growth to drop down to only 6% per year in 5 years time based on our research into the industry competitiveness. This growth includes inflation that is running at 5%, so in real terms it’s not that much at all. In our model the profit margins we calculated last week apply to each year of sales growth, giving us the PAT we expect going forward at the bottom of the page.

As a last point on growth: in the Internet and mobile world we get used to reports of applications, devices, or companies that grow 50% of more year on year. In the real world an annual growth rate of 10% is considered high. The higher the growth rate of the business, the more research you need to do to understand it, and the more variance (risk) you should expect around the returns.

Now that we can predict Profit After Tax going forward, we’re ready for next week’s discussion on how to calculate the cash the business actually generates, on which we’ll base our DCF valuation.

# Practical examples: adjustments to statements

This article uses an online model to work through the adjustments we need to make to a firm’s financials in order to compensate for non-market related owner’s compensation, discretionary expenses, one-time losses/gains, periodic expenses and non-operating expenses.

(Note that this model will be updated over time as we introduce further concepts and get into the full DCF).

Let’s chat about a Machine Parts manufacturing business we’ll call ‘Wobbly Machinery’. The business is for sale, and you are considering buying it. John Smith is the owner, and he employs his attractive (but not very bright) daughter Angela. Our challenge today is to look at a couple of numbers to quickly establish a view on the actual profits that the business is generating and that it might generate going forward.

The first tool that we use to look at any numbers is what’s known as the CAGR (compound annual growth rate). CAGR allows us to quickly calculate the average growth rate for sales, cost of sales, expenses and net income over the period. Since humans are not very good at understanding patterns where the year-on-year swings can be quite wide, the average over the period allows us to quickly spot the trend. The CAGR formula is (End value/Start value)^(1/periods in between)-1.

Using this, firstly, we see that sales have grown from R1M in 2008 to R1.3M in 2012, a CAGR of over 7%. However Net Income has grown only 2% in the same time. The immediate cause seems to be expenses, which have grown 10% during the same period. With margins decreasing so quickly, is there a business here we’re interested in? Let’s look through the adjustments to get the real picture:

John Smith pays himself R225K per year, and he pays attractive Angela R52K to play solitaire all day. If you were to buy the business, you’d pay a manager to replace John Smith (if you don’t do this, be careful that you are not just buying yourself a job), and you’d fire Angela. So the question is what would you pay for the manager? Some research by skimming through the jobs advertised in the classifieds tells you that you’d pay R100K in 2012. So all we need to do is deflate this number by inflation (at 6%) over the years to understand what it would be worth in 2008 onwards.

These calculations are shown in rows 12-15. The principle in each is that to Net Income we add back the actual salary/compensation then subtract what we’d pay if we were running the business.

The next step is discretionary expenditure, and here we see that Wobbly Machinery is paying a regular donation to a charity run by Angelas’ live-in boyfriend. Given that the charity has nothing to do with the business, we can safely assume that we will stop this spend once the business is ours. So we add it back in row 16.

The financials show a R520K loss from discontinued operations. It seems that John supported Angela’s idea of building an online application for Machine Parts, but that this hasn’t worked and they’ve written it off. It turn’s out that the prior attempts by Angela to build a business or explore an idea are what make up most of the prior-year’s losses from discontinued operations too, and they can be safely added back to get closer to real profits. (Lest you think this is unrealistic, this exact pattern is common in many family owned-businesses we’ve seen).

Lastly, we look at the lease and see that it comes up for renewal in 18 months, and quickly determine that if the business grows we’ll need to move. It looks like the business needs to move every 5 years or so, so we take the estimated cost of moving (using the real cost incurred in 2009) and split it across each of the five years to get a better picture of once-off/non-operational costs.

The result then is that we have Adjusted Net Income before tax (in line 21) that are far higher than those reported. In fact, they are nearer 7% on average than the 2% reported. Net income is nearly 4x higher than reported when we’ve adjusted carefully.

The last thing we should do is put some reliability estimate behind the numbers. Since more recent results reflect the future of the business more than results from 5 years ago, we need a weighting method. Accountants have a great method called ‘Sum of year’s digit’ to do just this, and its simple: you take the 5 years of statements (in this case) and add up the years to get 15 (1+2+3+4+5=15). Then you weight the profit margin from each year as 1/15, 2/15, 3/15, 4/15, and 5/15 accordingly and add them up. The results are shown in row 26, which when summed gives us a profit margin of 11.41%.

Now at last we have a starting estimate of reliable profit margins in the business that we can use to calculate its value going forward, which is where we’ll start next week.