The basic investment valuation model
Introduction
The basic valuation model lies at the heart of all investment decisions and, as such, is an important concept to understand.
It will give you a bedrock against which to make all investment decisions, whether regarding shares, property, or bonds. It will assist you to make dispassionate investment decisions, to avoid getting caught up in hype.
So, what is this magic model? The basic valuation model is the discounted cash flow model: quite simply, the value of ANY investment is the sum of its future cash-flows.
The future cash-flow for a single year is written algebraically as Ci/(1+r) (where C equals the cash flow, i is the year and r is the discount rate). For example, if you receive $100 in one year's time, the present value of the cash flow is $90.91, if it was discounted back at a rate of 10%. That is, 100 = 90.91/(1.1)
Therefore, the value of an investment is the sum of all future cash-flows, discounted at an appropriate rate.
There are three important concepts on which the discounted cash flow model is premised.
- Cash is king.
If you're measuring the value of a company on the NZSX Market, it's the amount of cash you'll receive that's important to you; that cash will help pay for your groceries and holidays. Don't be taken in by sexy metrics such as "users per line". Such metrics may help establish future cash-flow earnings, but they won't pay the bills. - The time value of money.
The value of a dollar today is more than that of a dollar you might get in the future. This is because there's a risk that you might not get those future dollars; if you had the cash today, you could always invest it in another investment. - The discount rate.
The discount rate applied to this cash flow model takes into account the risks described above: "an investment adds value if it generates a return on investment above the return that can be earned on investments of similar risk" (Valuation: Measuring and Managing the Value of Companies, Copeland et al). The discount rate, therefore, is an approximate rate you can use to test the potential profitability of an investment, while taking into account the risk of your project and the alternative investment options.
Of course, you then have to go and identify what those cash flows are. Over time, we will help you build models which will assist you in forecasting the future cash flows for shares, residential property and other investments.
Here endeth the lesson of Finance 101.
