M3 SAMPLE CASE

DISCOUNTED CASH FLOW METHOD (DCF) – CASE STUDY

Calculating the sum of the future DCF is the gold standard to find how much an investment is worth.
With this clear, let us use the DCF formula to get the value of a business. Let us say that you are an
investor who is being offered a deal to purchase a 20% stake in a business that has been in the market
for a very long time. And in this case, you also know the owner very well.
This business has been passed down for 4 generations and is still going strong. It has a growth rate of
about 3% per year. At the moment, it produces about $500,000 per year in free cash flow. So, if you
agree to invest into the 20% stake of the company, it will give you $100,000 per year in cash. And this
would also keep growing by 3% every year.
NOW THIS BRINGS UP A VERY BIG QUESTION: HOW MUCH SHOULD YOU PAY?
In the current year, the business will give you about $100,000. The next year, it will give you
$103,000 and the year after, you will get $106,090 and so on (this is obviously assuming that the
growth estimates are accurate). The stake in the business is worth an amount of money that is equal
to the sum of all future cash flows that it will produce for you. That is with each of those cash flows
being discounted to their present value.
Furthermore, as this is a private business deal with low liquidity, let us say that your target
compounded rate of return is 15% per year. If this is a rate of return that you know you can achieve
on the investment, you would only want to purchase this business stake if you can get it for a low
enough price that it would give you at least that rate of return. Hence, 15% becomes the
compounded discount rate that you apply to all future cash flows.
So, let us work on the equation for this:
DCF = $100,000/(1+0.15)^1 + $103,000/(1+0.15)^2 + $106,090/(1+0.15)^3 + … + CFn/(1+r)^n
DCF is the value we are solving for, which is the sum of all the future discounted cash flows and is the
maximum amount that you should pay for the business today if you want to get a 15% annualized
return. The numerators represent the expected annual cash flows, which in this case start at $100,000
for the first year and grow by 3% per year into perpetuity. The denominators convert those annual
cash flows into their present value as we divided them by a compounded 15% annually.
As a visual representation of this scenario, here is a table for the first five years that shows even as
the actual expected cash flows will keep growing, the discounted version of those cash flows will
shrink over time since the discount rate is much higher than the growth rate:
Year Actual Cash Flow Discounted Cash Flow

1 $100,000 $86,957

2 $103,000 $77,883

3 $106,090 $69,756

4 $109,273 $62,473

5 $112,551 $55,958

For instance, during the fifth year, you are expected to get $112,551 in actual cash flows. But it would
have a worth of just $55,958 to you today. This is because if you had $55,958 today, you could grow it
by 15% per year for the next 5 years in a row, and you will have turned it into $112,551 after those
five years.
Since the discount rate of 15% that we are applying here is much higher than the growth rate of
the cash flows which is 3%, the discounted versions of those future cash flows will shrink and shrink
each year and approach zero. Hence, even though the sum of all the future cash flows (dark blue
lines) is infinite, the sum of all discounted cash flows (light blue lines) is just $837,286, even though
the company lasts forever.
And this is the main answer to the original question. Basically, $837,286 is the maximum amount that
you need to pay for the stake in the business, that is if you want to achieve 15% annual returns,
assuming that the estimates for the growth are accurate. Plus the sum of the first 25 years of the DCF
for this example is $784,286. In other words, even if the company goes out of business a few decades
from now, you will get most of the rate of return that you had expected. This means that the
company would not have to last forever for you to get your money’s worth.