Content

• Steps
• Tips

Money is more expensive today than the same money will be in ten years. How do you understand how much more expensive they are today, and how much future cash flows are currently worth? Discounting future cash flows allows them to be brought to their present value.

Steps

1. 1 Decide on the discount rate to use. It can be determined using the capital asset pricing model (CAPM) formula: risk-free rate of return + asset sensitivity to changes in market returns For stocks, the risk premium is around 5%. Since the stock market values ​​most stocks over a 10-year period, the risk-free rate of return on them will be equal to the yield on a 10-year Treasury bond. For the purposes of this article, let's say it is 2%. So, with a sensitivity of 0.86 (which means 86% exposure to fluctuations in the market for investments with an average risk in the general market), the discount rate for stocks will be 2% + 0.86 * (5%) = 6.3%.
2. 2 Determine the type of cash flows to discount.
   • Simple cash flow - This is a single receipt of funds in the future, for example, receiving $ 1000 in ten years.
   • Annuity Cash flows are continuous cash receipts at fixed intervals over a specified period, such as receiving $ 1,000 annually over 10 years.
   • Growing annuity cash flows are expected to grow at a constant rate over a period of time. For example, over 10 years, an amount of $ 1000 will be received, increasing every year by 3%.
   • Perpetuities (perpetual annuities) - Continuous, non-expiring cash inflows at regular intervals, such as a $ 1,000 annual preference dividend.
   • Growing perpetuities - These are constant, non-terminating cash inflows at regular intervals, which are expected to grow at a constant rate. For example, a $ 2.2 stock dividend for the current year, followed by an annual increase of 4%.
3. 3 To calculate discounted cash flow, use the appropriate formula:
   • For simple cash flow: present value = future cash receipts / (1 + discount rate) ^ time period. For example, the present value of $ 1,000 in 10 years at a discount rate of 6.3% would be $ 1,000 / (1 + 0.065) ^ 10 = $ 532.73.
   • For annuities: present value = annual cash flows * (1-1 / (1 + discount rate) ^ number of periods) / discount rate. For example, the present value of $ 1,000 annually received over 10 years at a discount rate of 6.3% would be $ 1,000 * (1-1 / (1 + 0.063) ^ 10) / 0.063 = $ 7256.60.
   • For growing annuities: present value = cash flow * (1 + g) * (1- (1 + g) ^ n / (1 + r) ^ n) / (rg), where r = discount rate, g = cash growth factor flow, n = number of periods. For example, the present value of flows of $ 1000 with an annual increase of 3% over 10 years at a discount rate of 6.3% would be $ 1000 * (1 + 0.03) * (1- (1 + 0.03) ^ 10 / (1 + 0.063) ^ 10) / (0.063-0.03) = $ 8442.13.
   • For perpetuities: present value = cash flows / discount rate. For example, the present value of the $ 1,000 regular dividend on preferred shares at a discount rate of 6.3% would be $ 1,000 / 0.063 = $ 15,873.02.
   • For growing perpetuities: present value = expected cash flow next year / (discount rate - expected growth rate). For example, the present value of a $ 2.2 share dividend, which is expected to rise 4% next year, at a discount rate of 6.3% would be $ 2.20 * (1.04) / (0.063-0 , 04) = $ 99.48.

Tips

• Discounting cash flows on rising perpetuities can be used to estimate market expectations for a stock. For example, the current share price is $ 84, the discount rate is 6.3%, and the dividend per share is $ 2.2. What are the market expectations for this stock? Solving the equation $ 2.20 * (1 + g) / (0.063-g) = $ 84 we get the expected growth g = 3.587%.
• For calculations, you can use numerous online calculators, for example, this one.