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:
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!
This article originally appeared in Finweek.