Issue 110, 23 August 2002
Investor's College Investment equation pt 2 Discounting cash flows is a crucial concept for investors. In this second part in our series we show you how it's done. Last issue we introduced the investment equation and discussed arguably its most important component, capital protection. This time around we're going to examine the concept of discounting cash flows. Now, that may sound scary but it's not all that tough if you take it one step at a time. And it's an important process to understand because there's one thing both academics and investment practitioners such as Warren Buffett agree on. Intrinsic value That is, the intrinsic value of an investment is determined by the discounted value of all the cash it is expected to produce between now and 'doomsday' (as Buffett so eloquently puts it). As we'll soon see it's a straightforward concept but there are difficulties. The first thing we need is a little maths. Before we discount cash flows, we need to consider the simple interest formula: FV = PV x (1 + r) This is fancy-looking algebra for an easy concept. The idea is that the future value of your investment (FV) is equal to the present value (PV) multiplied by one plus the rate of return. Here's an example. Let's say that you have $100 to invest. That's your present value. If you earn a return of 10%, which is 0.10 as a decimal, then the term (1 + r) in our equation becomes (1 + 0.10) or 1.10. So it's simply a matter of multiplying 100 x 1.10 to come up with the future value of $110. Now let's assume that's an annual return (the formula is not time period specific) and we invest for two years. The calculation becomes 100 x 1.10 x 1.10, to end up at a future value of $121. But there's an easier way of writing this than FV = PV x (1+r) x (1+r) and it's:< /p > FV = PV x (1+r)n where n is the number of years (or time periods to be exact). So there you have it. That's all you need to calculate how much you'll end up with if you invest a given amount for a given time period at a given rate. Now let's work backwards. In the sidebar last issue we asked if you would prefer $100 today or $110 in a year's time. Well, let's manipulate the formula above to help us out a little. If we know the future sum due to us then we can calculate the present value by moving our formula around to: PV = FV/(1+r)n.< /p > So, let's say we demand a 10% return on our money. We can calculate how much $110 in one year's time is worth to us in today's dollars. The answer, will be $110/(1.10)1 . Or, of course, $100. That means we are indifferent to whether we receive $100 today or $110 in one year's time. Similarly, we can figure out the value today of receiving, say $115 in two years' time if we demand a 10% return. The answer will be calculated by $115/(1.10)2 . The answer will be $95. But how does this relate to the value of a share? We'll answer that question next issue so keep your eye out for it. For now, head to the sidebar for further discussion
C o p y r i g h t Š 2 0 0 6 The Intelligent Investor . Published by The Intelligent Investor Publishing Pty Ltd. ABN 12 108 915 233. Australian Financial Services Number 282288. PO Box 1158, Bondi Junction NSW 1355. Ph: 1800 620 414 Fax: (02) 9387 8674
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WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all subscribers.
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