DCF Basics. Why Discount Future Cash Flows?

One of the principals of Fundamental Analysis is called “DCF“ or “Discounted Cash Flow (Analysis)”.

An asset should be worth the money it will pay you over its lifetime. For example, a 5yr – 5% annual Bond is straightforward. You know (assuming no credit risks) you’ll receive a payment annually for the next 5 years, and then at the end of the 5th year, you’ll receive the last interest payment as well as your principal back. So let’s say you put in $10k, you’re receiving 5% or $500 each year, and then at the end of the 5th year, you’re getting the last $500 as well as the “original” $10k.

Now, although you are getting $12,500 in total, you will never pay $12,500 for those cash flows today. Because there are many risks associated with you receiving these cash flows. There’s Credit Risk, (will the company / Government / Municipality have the ability (or even willingness) to pay you.) Interest rate risk (The higher interest rates go, bond prices will decline (all else equal), etc. You therefore have to “discount” any money that you WILL receive. The rate that you will discount the cash flows is called the “discount rate”. This rate should be comprised of ALL of the risks associated with receiving the cash flows, added to the Risk Free Rate (or RFR, for another post). So say you want to discount the above cash flows (5yr bond) using a 7% discount rate, you plug it in your faithful BAII and you’ll get today’s current Fair Value of the bond… = $9,179.96

The Discount Rate is an extremely crucial variable in the equation of finding the Fair Value of a security. In the above example if you were to change the Discount Rate to 3%, the current Fair Value would rise to $10,915.94.

Apple Inc.

Apple makes great products, they revolutionized industries, bankrupted (once powerful) companies, are directly responsible for thousands of jobs created… and lost (via @businessinsider). That’s all nice and dandy. However, when trying to value the company by discounting all of their future cash flows, the key questions are, How certain are you that those cash flows will be there? Do they have long term contracts with their “end” customers? Where did all the customers come from?” (RIMM? PALM? THEORETICALLY, they can leave to another company for a better product just as quick as they came.) Because Apple is a consumer based product company, the Discount Rate due to the RISKS associated with receiving those cash flows has to be much higher than most would assume.

Contrast this with companies in the Wireless Tower sector (AMT, CCI, SBAC). (They have not only benefited GREATLY from AAPL, but also from AAPL’s competitors. Sort of like selling the picks & shovels to the miners.) Their customers are behemoths (VZ, T, S etc), the average contract or lease term on their towers are approximately 7- 8 years, and they have built in price increases on most of these contracts (an average escalator of around 3.5% a year). While this money isn’t as guaranteed as a US Treasury Bond, it is in my opinion, definitely more certain than saying AAPL will sell 50M iPhones in 2017.

Even MSFT, a huge portion of their business comes from enterprise customers, with “built in”, deeper relationships. I would say that their cash flows (set aside for a minute, if they’re growing or shrinking) are much more stable and predictable than AAPL’s.

So when discounting these cash flows & estimates, it’s fine to say, you’ll EXPECT AAPL to generate $50B in Free Cash Flow in FY15 – but the discount rate used to bring the value of that money back to today has to be a lot higher than what most people would think. Additionally, this discounting discount is amplified by the larger the growth rate, and the further out in time you go. Their 2020 cash flows for example, would have to be discounted for more years, and the discount rate has to be increased the further out you go, simply because the visibility will naturally decrease.

So what’s the Bull Case? Read David Einhorn’s Q1 letter via @marketfolly – he rightfully points out that AAPL’s growth rate is tremendous, and that its earnings multiple is less than the markets etc. but most of his points say nothing to the risks of their future earnings & cash flows.
What he does say however, is that (he believes) “AAPL is a software company”, and to me that’s the crucial point of his bullish thesis. As a software company with recurring revenues, sticky customers etc. you would have a lower discount rate.

Bottom line, unless you’re a fortune teller, every company’s “expected” Cash Flows have to be discounted by a different amount. The more visibly, stability, certainty etc.. the less they’ll have to be discounted. The more uncertainty or issues the company may have in attaining those cash flows, the higher the discount rate.

- MicroFundy