Basic Idea: Cash Flows, Timing, and Risk

Click here to watch the video “Cash Flows, Timing, and Risk” on LinkedIn Learning.

Let’s say that our mutual friend has asked me (or you) to become a partner in an online retail business.  This online retail business takes online orders from customers and then arranges shipment of the goods by various suppliers.  The major cash OUTFLOWS for this business are the compensation for the employees and the costs of the physical assets … the servers, the regular computers, and the office cost (rent, utilities, insurance).  The major cash INFLOW for this business is the commission fees received from the suppliers who pay the online retailer for attracting the buyers online.

So, our friend has asked me to become a partner by investing $100,000 of my hard-earned cash into the business.  With my $100,000 investment, will I now be a 5% owner? A 20% owner? A 75% owner? Of course, it depends on what the business is worth.  So, before investing my money in our friend’s business, I need to value the business.

Quick note: This discussion is merely intended to give you an idea of the process involved in such a business valuation. If you were really going to consider investing $100,000 in a friend’s business, I would strongly suggest paying a little money to hire a professional business appraiser to work with you through this process.

The BEST way to value this business would be to look at other similar businesses, find out some price multiples for those businesses (price-to-earnings, price-to-book, price-to-sales), and use those in valuing this business.  For the purpose of this example, let’s assume that no such data are available; you can’t find comparable companies, or you don’t have access to any accounting data or business value data for comparable companies because none of them are publicly-traded.  This is an important point. Your FIRST choice in doing a business valuation is to use the price-multiples which we discussed earlier in this course.  Only if you don’t have reliable price-multiple data will you then proceed to do the discounted cash flow analysis, or DCF, that we are going to illustrate here.

OK, in doing a discounted cash flow, or DCF, analysis, there are three important questions to ask as you conduct this business valuation.

1. How LARGE will be the future cash flows?

2. WHEN will those cash flows occur?

3. How RISKY are those cash flows?

Let’s consider each one of these questions.

First: How LARGE will be the future cash flows?  Your intuition tells you that the more cash that will be generated by a business in the future, the more valuable is that business.  As of November 2015, why is Apple worth $680 Billion but Kodak is worth only $520 Million?  The primary reason for the difference is that Apple is expected to generate much larger cash flows in the future.  For example, the FREE CASH FLOW generated by Apple in the single year of 2014 was $50 billion; the FREE CASH FLOW generated by Kodak in the same year was a negative $170 million, meaning that Kodak was actually CONSUMING cash rather than generating cash.  Hey, don’t worry, I’ll give you a definition of FREE CASH FLOW in a few minutes.  So, the larger the cash flows a business will generate in the future, the more valuable the business.

To value our friend’s online retailing business, we need to estimate how large the cash flows are expected to be in the future.  By the way, notice that I keep referring to the future. The reason is that when you buy a business or invest in a business, you are buying the FUTURE, not the PAST.  The PAST is of interest only to the extent that past results can help you in forecasting future results.

Second, WHEN will those cash flows occur?  Recall the concept of the time value of money we introduced earlier when we talked about the Income Approach to valuation.

To review, the concept of the time value of money can be summarized as follows: Cash flow now is worth MORE than the same amount of cash flow to be received in the future. It is essential to adjust for this time value of money when valuing a business. A dollar received far in the future is worth less than a dollar now.  So, as we do this valuation, we must be careful to forecast the TIMING of the future cash flows.

Third, how RISKY are those cash flows?  Risk is uncertainty about what will happen in the future stemming from variability in potential future cash flows.  In general, human beings don’t like risk.  Therefore, very risky future cash flows are worth less to me than are relatively safe future cash flows.

In our Discounted Cash Flow Analysis, or DCF, we will adjust for this riskiness through our choice of the interest rate … with more risky future cash flows, we demand a higher return on our investment, so we will use a higher interest rate in our analysis.  To review, the three things we must consider in doing a Discounted Cash Flow, or DCF, analysis are as follows.

1. How LARGE will be the future cash flows?

2. WHEN will those cash flows occur?

3. How RISKY are those cash flows?