DCF…What’s that?

Lets start with the basics, cash flow

Before I offer you a discount on your cash flow, let’s first figure out what cash flow is. To do so, let’s imagine I own a beer bar. Now let’s do a bit of math. It’s a really simple beer bar that has 2 expenses, rent and beer, and one source of revenue, selling beer. I have a fairly successful, but small beer bar that seats 10, but we’re always full. I’m not too fancy so we’re cash only and I pay all my bills out of the cash register We sell our beer for $5/bottle and get it for $2/bottle. Each customer buys 1 bottle of beer, and we’re open 20 nights a month. I have a really good distributor who is somehow able to supply me with beer whenever I need it, and I pay in cash every time I get delivery of a beer, but I have to pay my landlord at the first day of the month. Let’s look at my Cash Flow for the month.

The first day, I pay out $120, and I take in $50. But every day after that, I pay out only $20, I take in that same $50, for a net gain of $30 in the register.

For the whole month, I take in $1000 of sales, I pay out a total of $400 on beer (Cost Of Goods Sold; COGS), and I pay out $100 for rent; net $500. On the left is my Cash Flow Statement for the month.

As a bar owner, I’m making $500 of profit each month and that seems pretty good. But what about the flow of cash? What about days 1, 2, and 3 where I’m in the red? This is where your cash flow is very important. What if your patrons had a tab that they settled at the end of the month?

In this example, I’m still making $1000 in revenue, spending $500 on rent and beer, and making a $500 profit. The difference is there’s a lot more red. All of my income comes at the end of the month, so for days 1-19, I need to finance my operations. I can finance with last month’s profits, I can get a loan, or I can ask my landlord and distributor if I can pay them at the end of the month too. If I am able to manipulate when I pay my bills, I’m managing my cash flow.

Now that we have cash flow, let’s discount it

In Part 1, we discussed the “Time Value of Money,” where dollars today are worth more than dollars in the future. But how much more? How much would you pay right now to get $100 in the future? That number represents the “Net Present Value” or NPV. In our $100 bill example, there are 2 main factors that determine the NPV: how long you have to wait to get the $100, and what “discount rate” you use. This discount rate captures risk, inflation, and other factors. Calculating the exact discount rate is often quite complex, but a general ballpark is about 10% for a large, stable company and 15% for a smaller, riskier company. With the simple $100 payment, here’s the effect of time on the current value:

Let’s make an investment!

So let’s say a developer comes to me and says they can double my bar’s size for $20,000. In this example, to keep things simple, let’s look at monthly profits ($500) and use a discount rate of 15%. So our cash flow looks like the following

Is this a good investment? Well we can use a DCF analysis to see if the Net Present Value is greater than zero. If the NPV is greater than zero, then the deal creates value. Using a 15% discount rate, the NPV is about $10k, so this is a good investment.

How can you use this?

Discounted Cash Flow is something that gets quoted a lot. Essentially it’s boiling down all the ‘later’ money into today’s dollars. You can use this to evaluate investments that require up front payments, or to evaluate things that have payments both today and in the future. It helps you make apples to apples comparisons. To get you started, I’ve posted my excel worksheet, and feel free to play around.