Why Cash Is King
A Discounted Cashflow Analysis
Dear cherished readers, you’ve been with Milan and me on quite the journey. Together, we’ve navigated the calm waters of bonds and diversification, and even braved the choppier seas of risk and, more recently, private equity. Now, before you roll your eyes and mutter "more shameless self-promotion," hear us out: the links to those articles aren’t just gratuitous breadcrumbs—we promise.
They’re all connected by one fundamental concept that, astonishingly, we’ve never tackled directly. It’s the cornerstone of smart investing, the Rosetta Stone for understanding value: the Discounted Cash Flow (DCF) analysis.
Here’s the thing I’ll shout from the rooftops (and probably embroider on a pillow someday): the value of an asset boils down to the sum of its future cash flows, discounted back to today. This idea is as vital as it is magical, yet we’ve somehow never broken it down for you in the way it deserves. Until now.
So, in this article, we’re diving headfirst into the glittering alchemy of DCF analysis. We’ll dissect the essential components, walk through an example (complete with fictional flair—because real-life application is over here in this article), and shine a light on the hidden pitfalls. Then we’ll wrap things up by exploring assumptions and how qualitative analysis fits into the puzzle.
Ready to unlock the secret sauce to investing success? Let’s make your portfolio sparkle. Read on!
Basic Components
Let’s dive in by turning the idea of value into—brace yourself—a math equation. Don’t panic! If the thought of math triggers flashbacks to high school horrors, relax. You won’t need to memorize a thing. Here’s what the formula looks like:
Now, before you close this tab, let me break it down. Each letter in this equation represents something simple and powerful.
CF: Cashflows—basically, the cash a company generates during a specific period, usually a year.
r: The discount rate, or the expected return for an investment. It factors in risk, meaning riskier investments demand higher returns. You can calculate this using measures like cost of equity, debt, and betas—or, you can just set it at a target return, say 10%. Bonus: This can even be used to assess different investment scenarios, but that’s a topic for another day.
t: Time. And time is where things get juicy.
Why is time so crucial? Because its impact is exponential. Let me paint you a picture: you invest €100 at a 10% expected return. By the end of year one, you’ve earned €10. Simple enough, right? But now your new starting point is €110 (€100 + €10). In year two, you earn €11 (10% of €110). Year three? €12.10. And so on. This snowball effect, known as compounding, is like an investor’s best friend—and, honestly, one of the coolest tricks in finance.
The math here also reveals some universal truths:
Higher cashflows equal higher value (because the numerator grows).
Higher expected returns (aka opportunity costs) mean lower present value (since risk is baked into the denominator).
The farther in the future a cashflow is, the less it’s worth today (because the uncertainty grows).
Got it? Good. Now let’s see this in action. Remember The Golden Croissant? They’ve gone public and are rolling in dough—literally. The perfect example to showcase the magic of DCF!
Example - The Golden Croissant
Let’s face it—every DCF analysis begins with assumptions. And while assumptions can feel like educated guesswork, two of them are absolutely crucial: (1) how much the company is reinvesting to grow and (2) how efficiently it’s doing that. These concepts have fancy names: the Reinvestment Rate (RR) and the Return on Invested Capital (ROIC).
Now, picture this: a company that reinvests more of its profits is naturally going to grow faster—makes sense, right? But the real magic happens when a company gets more back for every dollar it invests. That’s when growth becomes not only faster but also sustainable. Multiply the RR by the ROIC, and you get the growth rate—the golden number for DCF analysis.
Since this duo deserves its own spotlight, I’ll break it down in more detail in a future article. So hit that subscribe button if you don’t want to miss it!
Here’s where it all ties back to operations. A DCF analysis focuses on a company’s operational profitability, excluding the influence of debt. That’s where Net Operating Profit After Tax—or NOPAT for short—comes in. It’s just a fancy way of saying:
“What would the company’s profits look like after taxes if it had no interest payments?”
It sounds complex, but it’s really just recalculating taxes on Earnings Before Interest & Taxes (EBIT). Example? A €100 EBIT with a 25% tax rate gives €25 in “operational taxes.” Boom—done. Combine NOPAT with your discount rate (remember our hurdle rate?), and you’ve got the foundation for a DCF.
Let’s get practical. Our beloved Golden Croissant is expanding, and we’ve modeled its growth over three phases. In the Growth Phase (Years 1-3), this is the “go big or go home” stage. They’re reinvesting heavily—opening stores, buying ovens, and riding their momentum. Here, ROIC improves as costs per croissant shrink, thanks to economies of scale.
Then, in the Transition Phase (Years 4-7), reinvestment slows down, stabilizing at a constant rate of 20%. Why? Because finding worthwhile investments gets harder as the company grows. Meanwhile, competition starts nibbling at their margins, causing ROIC to dip back to earth.
Finally, in the Mature Phase (Year 7+), growth settles into a steady rhythm, and reinvestments are modest. Golden Croissant now faces a tougher battle to maintain its edge.
Once NOPAT is calculated, it’s time to figure out the Free Cash Flow to the Firm (FCFF). Here’s the recipe: Start with NOPAT, subtract investments made to grow, and add back depreciation (since it’s not an actual cash cost). Adjust for working capital, which reflects the day-to-day cash needs of the business. (Don’t worry—I’ll cover working capital in detail in a future article.)
Now comes the fun part: discounting those future cashflows back to today using the Discount Rate. The further into the future a cashflow happens, the less it’s worth today—thank you, compounding.
But wait, what happens after Year 10? Companies don’t just disappear overnight (certainly not the mighty Golden Croissant!). Enter the Terminal Value—a fancy name for estimating the company’s value beyond the forecast period.
Here’s a truth bomb: No company lasts forever. Unfortunately, not even The Golden Croissant. But since cashflows after 30 or 40 years barely move the needle (thanks again to discounting), we focus on the first few decades. To keep it simple, I’ve assumed a perpetual growth rate of 3%—in line with long-term inflation forecasts. ROIC, too, eventually settles at the sector average.
Now, we just add up the discounted cashflows, subtract the company’s debt (because debt belongs to lenders, not shareholders), and add back cash (because it’s an extra gift for equity holders). Divide by the number of shares, and voilà—the estimated value per share is yours.
For those of you eager to value your own favorite company, I’ve got you covered: there’s an Excel file waiting for you at the end of this article.
Pitfalls & Wrap-up
At its core, a DCF analysis is really just number crunching. That’s the “technical” part—and truthfully, it’s not rocket science. But here’s the catch: numbers are just numbers. On paper (or in a polished Excel file), it’s easy to make any company look like the next big thing. Tweak the inputs a little here, a little there, and boom—you’ve got the “best company on Earth.”
You’ve probably heard of GIGO: Garbage In, Garbage Out. If you feed the model bad assumptions, you’ll get bad results. It’s that simple. That’s why being comfortable with the numbers is so important. Think of it like driving a stick shift: at first, you’re just focused on not stalling. But once shifting gears becomes second nature, you can focus on the road, the traffic, and everything that actually matters.
The same principle applies here. The more effortless the number crunching becomes, the more attention you can give to the input—because that’s where the magic happens. Your assumptions about reinvestments and ROIC are the backbone of a DCF analysis. They’re what shape the final result.
And where do those assumptions come from? This is where qualitative analysis steps in. You need to dig into the company: its operations, its management, its sector, its business model, and most importantly, its future. How does it make money? Who’s steering the ship? Can it survive—and thrive—in the long run? The answers to these questions will ultimately influence your reinvestment rate, ROIC, and, in turn, the cash a company generates.
What’s clear here is that qualitative and quantitative analysis go hand in hand. One without the other is incomplete, and striking the right balance is the key to accurately valuing a company.
Don’t worry—we’re just getting started. There’s plenty more coming your way on valuation, so stick around. For now, though, it’s your turn. Pick a company you love, grab your calculator (or Excel), and give it a shot. After all, practice makes perfect. You might just surprise yourself.
