4.3 NPV and IRR
And in this section we're gonna look at the third and final way of valuating company, which is discounted cash flows called DCF. At the same time, we've even got a check and balance in here, because we can use the free cash flows to calculate something called IRR, internal rate of return. And you can get out of this problem if you really wanna take an advanced math class and learn the equations in calculating IRR, you can get around this.
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Welcome back to the final section of module 4 on valuation. And in this section we’re gonna look at the third and final way of valuating company, which is discounted cash flows called DCF. A discounted cash flows is often considered the most thorough way to valuate a company. Discounted cash flow uses the company’s free cash flows and a discount rate to calculate what we call the NPV, or net present value. And this is not only used for companies but it can also be used for projects. It can be used for individual investments, it can be used for portfolios, okay? At the same time, we’ve even got a check and balance in here, because we can use the free cash flows to calculate something called IRR, internal rate of return. And we’re gonna actually be looking at both of those throughout this process. Let’s talk first about net present value. What is net present value? Net present value takes into, to consideration the concept of the time value of money. What’s the time value of money? Quite simply, money today is worth more than money later. Right, money now is worth more than money later. If you give me $100 today, and I promise to repay you that $100 a year from now, you’ve lost, because a year from now, $100 is not gonna be worth what it is today, for a couple of reasons. One, there may have been inflation, and $100 is worth a little bit less. And also, there’s the benefit that you could have made with that $100. So money more is worth more than money later. So how much more, right? What, what, what is, how much more is money worth a year from now than today? It’s not just the inflation rate. It depends on who has that money, how they’re gonna use that money. It depends on what we usually call our next best investment, or next best opportunity. So, there’s a few different ways we do this and there’s a few different titles we give it. The, the, the cleanest one is when we’re evaluating a company, we’re looking at the discounted cash flows of a specific company. Let’s go back to the Gap, for example. If I looked at the Gap, and I wanted to know what is Gap’s money worth today as opposed to later? I wanna know how much money costs them, okay? There’s another concept. Money costs us. When I get money from somebody, I have to pay for that money. You gotta buy money. You gotta buy money at more than you’re buying it for. When you go out to buy a car, and you get a car loan, right? Some bank gives you a loan. You pay them back more than they gave you. Why? Because money costs more than what you’re getting, right? You, the, the premium on the money that you’re paying, you think of as your interest rate. What’s my APR, my annual interest rate, ‘kay? That’s what you’re paying for your money. Well, what does Gap pay for their money? Well, it depends where they get it from, right? What are the main sources of money? There’s debt and there’s equity, ‘kay? Debt is when Gap goes to their banks and says, hey, we’d like to borrow money, ‘kay, and the bank says, sure. We’ll loan you this much. Here’s your, here’s your interest rate, which is usually decently low, especially for a huge company like Gap. There’s another way that Gap can get money also. They can go to the market. They can get investors. That’s equity. They can basically sell stock. Now, in business rule of thumb, debt is cheaper than equity. I’ve said that before already. Debt is cheaper than equity. ‘Kay, so it costs us less to go to the bank than it does to go in the market, which is why in the last section where I was speaking about the last module and we were doing ratios, spoke about the debt ratio, right? And we actually like to see about two times as much debt as we have equity. So we have $1 million in equity, we’d like to see $2 million of debt, right? Two to one is a nice ratio there that the market tends to like. Well, why not all debt? Well, all debt, and you’re extremely leveraged, you might have trouble paying back some of this you know, sa, some of this money that you owe. Because the thing about debt is debt usually has a payment schedule attached to it, gotta pay on time. Whereas equity, it’s investment, you only pay your owners if you make money. When you make money they expect more, okay, so debt is cheaper than equity. So Gap has two ways of getting money. They can issue, they can, they can accept, they can get some debt or they can get some equity. So what’s this costing them. In the case of Gap or any other company, any other publicly traded firm and even some non-publicly traded firms, we have a method called WACC, the weighted average cost of capital, which I’ll explain a little bit more about as, as we move on. The weighted co, average cost of capital is going to be that company’s discount rate. The discount rate is kind of like their APR, right? It’s what they pay from money. So when we calculate the weighted average cost of capital, we can discount their future cash flows by that amount of money, right, and see what it’s worth in the future. Okay, so money now is worth more than money later. The essence of NPV, how does this work? Let’s go back to our Gap example, right? I’m the I’m the CEO of Gap, or the, ma, I’m on the board of directors, and Gap is looking at buying another company, right? And buying another company, and maybe they manufacture some clothes, or design something, whatever, there’s a company out there and we wanna, we wanna purchase that company. Is this a good investment? Is purchasing that company worth it? Well we’re gonna have to do a couple things first. First, we’re gonna wanna look at that company’s cash flows. And more importantly, we’re gonna wanna look, we’re gonna have to project that company’s cash flows. Because that company, if we buy it, probably will run a little bit differently. In fact hopefully it will be a lot better company once they belong to us. So we’re gonna project their cash flows, okay? And then we’re gonna, and we’re also gonna have to look at how much are we willing to pay for that company, what do we want to buy it for. So we have what we’re thinking of as a purchase price, right, which is our investment. We’ve got projected cash flows, what we believe that company is gonna bring in. And now we need to look at what does money cost us? So we simply calculate our WACC. We call finance, and we say, hey, what’s our WACC and they better know it off the top of their heads, really. And they tell us, okay, our WACC is 12.4%, whatever our WACC is. And we discount those cash flows by 12%, by our WACC. And we get an NPV, we get a number, a net present value. Now if that NPV is zero, very unlikely, right, but if they had zero, then that means we make no additional money. This is break even, right? We make no additional money by in, by engaging in this investment and we lose no money. So really, because of the risk that’s always involved in an investment, I would probably not touch it if the NPV was zero. If the NPV is negative, then that means that the money would return to us, is worth less in today’s money than the money we’ve put in. And this is why we discount cash flows. Cuz you could look and say, oh, but we’re buying that company for $1 million. And if we just, if we just sum up the cash flows that we get over the next five years, that comes to $1.5 million, right? So 1.5 million, we’ve made $500,000. No, no, no, no, no because money now is worth more than money later, and it turns out, possibly depending on how that money comes in, and the discount rate, it could be that that 1.5 million discounted is less than 1 million in today’s money. In which case, it’s a bad investment. Or, the NPV comes back positive. NPV comes back at, you know, $300,000, $200,000. It comes back greater than zero. If it comes back greater than zero, then that means it’s a good investment for us. Because currently we’re paying 12.4 whatever I said, 12 point something percent for our money. And assuming that that’s what this money costs us, that, that we’re investing, we’ve actually brought back more money in. So that’s the concept of NPV. We’re looking for something that greater than zero. So as I’ve said, there’s NPV, which we get from discounted cash flows. Now we can also calculate, from those same, from the same cash flows, we can calculate what’s called IRR, the internal rate of return. Now NPV gives me a monetary value, right? It says that this investment is worth, in today’s money, $200,000, $300,000, whatever it is, right? Because the money that I’m gonna get back from that company, once discounted, is worth this premium. So that’s what it’s worth to you, okay? IRR is gonna give you a percentage. It’s almost as if this is you, the rate of return on your money. In fact, internal rate of return, that’s what it is. It’s the percentage rate of return. So we run IRR the same one way we run NPV. We use the Excel function. We say IRR equals, and we try to get that. And IRR will then say, for example, 21%, right, and that’s the rate of return on the money. Now we can also take that and compare it to our WACC, right, our discount rate. If the IRR is greater than our discount rate, it’s a good investment. If the IRR is less than our discount rate, it’s a bad investment. We’re gonna lose money, okay? I like to do both, I like to perform both NPV and IRR. Managers tend to prefer IRR for some reason, they like to know the percentage they’re getting. Entrepreneurs, investors usually like NPV, they like that monetary value. Now since NPV actually yields a dollar amount, only NPV can be used to valuate company, give you an actual value of what that company is worth. There’s also, there’s a problem with that IRR. And you can get out of this problem if you really wanna take an advanced math class and learn the equations in calculating IRR, you can get around this. But if you’re like me and you’re gonna use Excel to calculate NPV and IRR, Excel can sometimes the, the embedded formula can have a problem with IRR. If cash flows go po, go, they start negative always cuz you make an investment so it’s starts negative, it goes positive, if it goes negative again and then goes positive, your IRR may be flawed, right, might, might not, you don’t know. But it may be flawed. If that’s the case then you have to use NPV because IRR doesn’t make any sense. You actually can check it. Okay, so remember when I said that you want the IRR to be big, to be greater than your discount rate. If it’s greater than your discount rate, you’re making money. This is because there’s a, there’s a relationship between the discount rate and IRR. IRR, if you make the IRR your discount rate, so change it from whatever your WACC is to what the IRR is, your net present value should be zero, okay? Cuz that’s the actual discount rate of the, of the money to, to make the NPV equal zero. So you can check your IRR. Take whatever Excel says your IRR is, put that in as your discount rate in your net PV function and, your net, your net present value should be pretty close to zero. Sometimes it can be up or down a little bit because you’re not putting in enough def, decimals. But if you actually just copy and paste the equation, it should actually equal zero. So you can check the IRR in the event that you have fluctuating cash flows, to make sure that NPV, that Excel is properly calculating it. So that’s a very brief, a basic overview, of how you use cash flows to valuate a firm, by discounting them with the discount rate, which we’ve been calling the WACC, the weighted average cost of capital. Now there’s also, in the times when we don’t say WACC, we just say discount rate. Because, how about if I, if, if I want to invest in a project, what’s my WACC, right? I’m not gonna call it a whack, right? It’s gonna, I’m gonna call it my discount rate. My discount rate is going to depend on a couple of things. First of all, I don’t issue stock in myself, right? So there’s no market out there, right, people buying equity in me. What I have is I have my next best opportunities, right? What’s the bank gonna give me if I take my $20,000 and put it in the bank, what’s the bank gonna give me? If I take and loan it to my brother, what’s my brother gonna give me, right, if I charge my brother interest? What can I do with this money, right? There’s also what kind of risk do I associate with this money? ‘Kay, if I’m gonna give you money to start a business, how risky do I think that is? So, I’m going to decide what a discount rate that I want. And, that discount rate basically, is a monetization of risk. And, it’s the same with, with WACC. WACC is simply a monetization of risk. It’s how the market the, the, the, the equity market and the debt market evaluate the risk of that company. Okay, so that’s the discount rate. And you can Google this, you can research this a little bit more and understand it a little bit more, but finding the discount rate, understanding the discount rate is important, not just for a, a a company but even more importantly really for yourself. Is what is my discount rate, what do I expect as a return for the money that I invest? Now in case you’re wondering, and I wasn’t gonna show you the, the big complex formula or anything, but I do wanna show you really quickly how a very simple WACC would be calculated. We say weighted average cost of capital. Okay, so we have to weight the average. Basically let’s look at a, a company. The company has 45% debt at 6% interest. So 45% is, is debt at 6%, 55% is equity at 13%, right? Debt is cheaper than equity. So their WACC is going to be the weighted average 45% of times 6%, 55% times 13%, and that’s gonna give us a weighted average cost of capital of 9.85%. So that would be the discount rate that that company would use, and they would want any investment that they got into to have an IRR greater than 9.85%. And using 9.85% as their discount rate, they would want NPV to return a value greater than zero. That’s how you calculate a discount rate. That’s basically what it is. And this concludes this module and this course on finance for non-financial professionals.
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