November 20, 2020

In this video, I will walk you through one of the more complex valuation approaches when it comes to investing - Discounted cashflow.

You have probably heard of discounted cashflow but you are not what it is and how it works.

If so, then this video is made for you. We will be going through what it is, how it works and go through an example as well.

90% correct transcript

Eric here. And in this video, we're going to talk about discounted cash flow. What is this counted cash flow. How do you use it? And we're also going to walk through one example about this counters cashflow. So I'm going to try to keep it as simple as possible for you so they can understand it. And you can decide whether you want to implement this as part of your investing strategy. So let's get started. So before we start, I just want to congratulate Kant for making 90% from chef warehouse in two months. Congratulations cons. And this is the 55th case study in investing accelerator. So right now we're doing a hundred likes books giveaway. So if we reach a hundred likes in this video, then I'm going to select one winner from the comment section below, and you're going to win the warm busted way, the third edition.

So if you're interested in reading this book and getting it for free, then you can leave a comment below and click like on this video and remember to click subscribe as well. 98% of you guys are not subscribed yet. And it would really help me out. If you click on the subscribe button, it is free and you can always change your mind in the future. So this is the part two series to really address Philip Chang's comment requests on valuation methods. And here is actually an interesting quote I found on this counter cashflow intrinsic value can be defined simply is to discount it value of cash that can be taken out of a business during its remaining life. The calculation of intrinsic value DOE is not so simple. As our definition suggests intrinsic value is an estimate rather than a precise figure. And it is additionally an estimates that must be changed if interest rates move or forecasts of future cash flows are revised Warren Buffett's.

And I think this is a beautiful quote. Now it talks about the complexity of this counted cash flow, but it's not necessarily helping you in terms of understanding what it is, how can you use it to your advantage and what you should do with it once you learn the concept. So that's what this video is about. Now. Discount cashflow is a sum of all future cashflow today. Okay? So that means you're bringing everything that's. This company is going to earn in the future and you're trying to evaluate what is that worth today? And discounted cashflow has two parts. It has the discount thing factor, and also the cashflow part of it. Now cashflow is just how much money the company's going to make year after year. But then you might be wondering, what is discount? You know, what is the discount rates? How does it work?

And why is this so important and what is a reasonable discounts rate? So that's what we're going to do. So how does this counting work or in another way of asking the same question, why is my cash worth less and less over time? Or another way to ask the same question is how to legally Rob everyone's money without their consent. So here is a hundred dollar bill in us. The way discounting works is today a hundred dollars is a hundred dollars is a hundred dollars, but a year from now there's inflation. So the hundred dollars a day is worth less is only worth $97. And if you hold it in cash, then it's going to worth $94 and $91, and it's going to work less and less. And that is really because of a couple of factors. First there's something called inflation, which means all of the prices around you are increasing by two to 3% each year.

So that means wages, food, transportation, everything increases by two to 3% per year. Sometimes they increase this more, but on average is around two to 3%. And if you don't do anything with your money is not increasing by two to 3% per year than it is for thing less. So a hundred dollars in year one will be worth less than a hundred dollars today because people who invest that $100 will get 102 or $103. So that is how discounting works. So the 97 94 91 represents your purchasing power. So your number, you know, your bill is still a hundred dollars, but you can buy less stuff with it because the prices of food, transportation, and wages are going up. So over time you can purchase less and less and less. So what if you hold cash? You know, there's actually a very common concept among older generation to put cash under the mattress, to put cash at B below the house to put cash in certain weird places, because it is safe.

And here is how inflation works over 10 years. This is actually how discounting works over 10 years. So a hundred dollars is what you have today and that represents your purchasing power. So that's a hundred dollars worth of stuff you can buy. Now, if you hold cash for 10 years. So in 10 years, you will only be able to buy $73 worth of stuff. So that's a 27% decrease. And in 20 years you can only buy $54 worth of stuff. That's a 46% decrease. That's actually quite significant. And if you have some idle cash for 20 years, wow, you lost half the value rating. And in 30 years you lose 60% of the value. So you can only buy $40 worth of stuff. And this is really discounting in action. And you just got to think about what I'm showing you right now, but backwards.

So a hundred dollars in year 30, and you bring it back today is not going to worth as much as if you have a hundred dollars today. And I know a lot of people or the older generation like our grandmas and so on, like to put cash in a tin can or some sort of cookie can, and they put it there for years and years and nobody ever noticed. So over time, what happened over time, this happened it's worth less and less and less. So that means it's much better to just put the money in a savings account where you're earning 1% interest or something, at least. So then you're not decreasing. I quick as quickly, or I put it in something like money market fund, where you're maintaining the same growth rate as inflation. But if you put it in a tin can underneath your bed, then over time, the $100 is going to work less and less until it's going to lose like 60% of its value over 30 years.

So let's imagine a situation when there's no discount rates. And that's quite important because you know what, if someone comes out and say, well, let's not have inflation anymore. So this means people can borrow money without consequence. Now this is a generalization, but you just got to understand what happens if there's no inflation. And that means if you borrow, if I pour a hundred dollars from you today for 10 years and I pay you back, it will be exactly a hundred dollars and that earned Ciro interest and their Sera inflation. So when you think about it, then you can imagine, is it fair? And doesn't make sense when people actually implement that or would they want some sort of compensation in addition, on compensating, on the interest as well. And when you think about inflation, it's really like a self fulfilling prophecy because people expect wages to go up by 2%.

So that leads to products and other prices go up by 2%. So then that leads to them expecting wages to go up by 2%, even more so on and so forth. So it was really a self-fulfilling prophecy in this case. So the better question is, well, what is a reasonable discount rates or what is a reasonable rates of decline for everyone's money without everyone off and causing a revolution and issuing a new currency altogether. And as you have studied world war II, when Germany lost a war, they actually printed a lot of money and that led to hyperinflation. And basically you can't even buy a piece of bread unless you have thousands or millions or millions of the local currency there that has happened to Venezuela and other countries where they printed massive amounts of money. So let's talk about some of the options you have.

You can use inflation, you can use your investment targets, for example, like 30% where it's aggressive, you can use a random number generator, you can use her next best investment return. So your best alternative, which is kind of like the opportunity costs, you can use the fed printing money. So you can just put a random number in there, or you can use the first digit of your birthday. And we all know, you know, what's the right answer. So I'm not even going to bother going through it. Now we're going to jump into an example and let's use EA as an example. So here, I'm going to go to and we're going to pull up the electronic art, which is, um, a company I talked about in the last video. It's a gaming company and it is quite mature. It does make money. And the way it works is that you want to start with the annual income statements.

So here, when you're looking at it, is actually going from right to left. So make sure you're not looking into your other direction because in North America you usually go from left to right in terms of the period. So this is 2017 to 2020. Okay. Now you will see that there a lot of stuff happening here, which I'm just going to skip over and look at the most important line, which is net income after taxes. So this is actually how much the company's making each year, right? So this is the income statements. And then you look at net income. Now, technically you should look at cashflow, but for this example, I'm just going to look at net income for simplicity. If you look at cashflow, then you want to look at operating cashflow minus CapEx. But depending on how precise you want your model to be, uh, you can be very, very precise and make a ton of adjustment.

Okay? Now, using this number, you want to model out what you think the cashflow or the net income will be for the next five years. So you're not using these numbers for discounting, but instead you're using what it is going to be for the next five years. Do you think it's going to be greater than $3 billion? So this is in millions. So 3000 million is 3 billion. Or do you think it's going to be flat or do you think it's going to be declining? So you see this part is where you apply your judge. Now, some people who do a ton of research on their stocks that they invest in, they will be able to better forecast the net income for the companies than people who don't do their research. And that's why doing research is so important because usually when you're looking at a discounted cashflow model, you will be looking for at least five years.

So as me and you, as the retail investor, we're not really planning to budget for the company. And you can see that this can be quite judgmental and also requires a ton of work to determine what the next five years of net income will be, because you can change any of the numbers up here, and that will influence the net income number down here. Okay? So you can see how complicated it gets already. Now, after that, then you want to add something called a terminal value. So at the end of five years, you want to add, how much is this company going to make for the rest of its life? Now, this can be really complicated, even though there is a simple way to do it, but what you're decentrally doing is you're guessing how much this company's worth in five years. So for example, if you think this company will make 3 billion a year every year until the end of time, okay?

And the discount rate you end up using is 10%. Then you would take 3 billion divided by 0.1, which is 10%, and that will get you to 30 billion. So that's the terminal value, which is instead of model modeling out each year, you just apply a number, which it goes on forever. So did this number. If you just change the discount rate slightly, Hey, we just changed the net income slightly. It will change this number significantly. That's another layer of complexity that is being added here. And then afterwards, do you want to adjust for any surprising events? Now, what I mean by that is when you're looking at the net income here, you're using this to project into the future. And when you look at 2020, there might be some surprising events that led to a higher net income than expected. So for example, why is there a negative provision income tax?

Like, is this a one off event? Should you be adjusting this? And you want to adjust all of this before you make that forecast so that it is as accurate as possible. A lot of times professionals or people in finance will adjust for these surprising events. So then they get a more accurate, um, discounted cashflow model. But if you are a retail investor, chances are, you're not going to be spending that much time on a discounted cashflow model. So then it's really up to you on how precise you want to be. Then you'll use a discount rate, you desire and discount it back. So now we have gone through an example, you probably understand how difficult it is to do a discounted cashflow. People can spend, you know, a full time, a couple of days, just to Mala model out a discounted cashflow in my firm.

People spend anywhere between three to five days and they actually have all the templates ready. They have all the formulas ready and they actually model out different assumptions. They do a sensitivity analysis. So is it practical for everyday investor to do that? When it comes to investing, the chances are, is probably not. And if you use a multiple approach, which is the video I talked about previously, daddy discount rates and terminal value is already built into the multiple itself. So for example, if you're using a PE ratio of 15 or P ratio of 20, then the discount rate, the terminal value, all of that stuff is already built into it, into the multiple already. So it's all taken care of. So when you think about, you know, discounted cashflow, what do you really need to consider is, well, what if there's something weird on the financial statements?

Are you able to spot that and adjust for it? What about the emotions of mr. Markets? You know, what, if he is happy one day and it's unhappy in other day, how can you take advantage of the emotions of mr markets? And what about the irrationality of mr. Market? You know, the market is not always rational. It doesn't always behave. Like, what do you expect it to, for example, yesterday, it was dropping quite a bit. So what are you going to do with that? And how do you build that into your investing plan? So then you become successful. And in terms of my personal investing goal, my goal is really to make around 30% a year. And when I first started, this seemed like a stretch goal. To me, it's like going to Mars and I was losing money. I had no strategy, no idea what I was doing, but in the last five years, I figured out the strategy that really worked for me.

And I earned a 558% in the last five years. So my goal is really to make 30% a year. And in the next 10 years, I want to 10 times my account. So it's around a thousand percent return and that's my goal. And during my spare time, I help people with photo financial background to target 30% from the markets using an hour week. So this is really the transformation I've made. I have went from a newbie to a professional I've went from a person with no investing plan, no strategy, no financial background to a person who have a proven, profitable and simple strategy. My goal is really to build generational wealth across many, many years and teach my kids how to invest as well. So they can benefit from the power of compound interest so they can benefit and the joy of investing. So here's a case study that we celebrated today, where a consummate 90% from chef in two months, as you want to learn more about investing a celebrator and learn how to use technical analysis properly, how to analyze the financial performance of a company.

So then you can do it very quickly. Then click on the link below and watch the free webinar, how to get 30% from the stock markets in the next 12 months. So it was the first link below. And once you click on it, then you can register and you'll be able to watch that free webinar right away. And in terms of this video, we're doing a a hundred likes giveaway. So if you leave a comment below like this video, when we reach a hundred lights, then I will select a winner to get the book, the Warren Buffett way. So, um, I think this is quite a good book. So if you are learning fundamental analysis, you're trying to evaluate the financial performance of a company. Then you should pick up at least one book from Warren buffet. Okay. In the next video, we're going to talk about two tips to retire faster and achieve escape velocity in direct race. So this is quite an interesting topic because what is escape, velocity, and how can you retire faster? And if you understand these two concepts, then I think you achieve much better in terms of your financial wealth. And also you have much more confidence when it comes to investing. So I'll see you in the next one.

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About the author 

Eric Seto

Investor, CPA (Canada) based in Hong Kong and Vancouver

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