core concepts Flashcards
(19 cards)
- What does the “Discount Rate” mean?
The Discount Rate represents your opportunity cost or your “targeted yield.”
In other words, if you don’t invest in this company or asset, how much could you earn with your money
elsewhere?
The Discount Rate represents both the potential returns and the risk of other, similar opportunities.
If the Discount Rate is higher, both the potential returns and the risk are higher; the opposite is true if the Discount Rate is lower.
- Why is the Discount Rate higher for stock-market investments than it is for debt investments, such as lending money to others?
Because the risk and potential returns of stock-market investments are both higher.
Over the long term, you might earn an average of 10-11% per year in the stock market.
But in a given year, the market might fall by 30% or rise by 40%, so the return each year varies tremendously.
With debt, by contrast, you’ll earn a fixed amount of interest every single year with a very high certainty.
- What is WACC?
WACC stands for “Weighted Average Cost of Capital,” and it’s the most common Discount Rate used to value companies.
To calculate it, you multiply the % equity in a company’s capital structure by the “Cost” of that equity, multiply the % debt in the company’s capital structure by the “Cost” of that debt, and add them up.
For example, if a company is using 60% equity and 40% debt, and its cost of equity is 10% and its cost of debt is 5%, its WACC is 60% * 10% + 40% * 5% = 8%.
WACC represents the average annual return you’d expect to earn if you invested in the debt AND equity of a company and held both of them for the long term.
NOTE: This is a simplified explanation. There’s a whole lot more to WACC - please see the sections and lessons on DCF analysis and valuation for more.
- You estimate a company’s WACC as 8.0%. What does that mean?
It means that if you invested proportionately in both the company’s equity AND its debt, you’d expect to earn 8.0% per year from the investment, on average, if you hold it for the long term.
In a specific year, your returns will vary because the stock market can swing around wildly.
But WACC represents your long-term, average expected return.
- How much would you pay for a company that generates $100 of cash flow every single year into eternity?
It depends on your Discount Rate, or “targeted yield.”
For example, if your targeted yield is 10%, you’d pay $100 / 10%, or $1,000, for this company.
But if your targeted yield is 20%, you’d pay only $100 / 20%, or $500, for this company.
If there’s no growth, the formula is always the same: Company Value =
Cash Flow / Discount Rate.
- A company generates $200 of cash flow today, and its cash flow is expected to grow at 4% per year for the long term.
You could earn 10% per year by investing in other, similar companies. How much would you pay for this company?
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate).
So this one becomes: $200 / (10% – 4%) = $3,333.
Remember that a higher Discount Rate makes a company less valuable, and a higher cash flow growth rate makes a company more valuable.
- What might cause a company’s Present Value (PV) to increase or decrease?
A company’s Present Value might increase if:
- Its expected future cash flows increase
- Its future cash flows are expected to grow at a faster rate
- Our “opportunity cost,” or Discount Rate, decreases because we lose access to certain investments.
A company’s Present Value might decrease if:
- Its expected future cash flows decrease.
- Its future cash flows are expected to grow at a slower rate
- Our “opportunity cost,” or Discount Rate, increases because we gain access to more appealing investments.
- How do you decide whether or not to invest in a company or asset?
It makes sense to invest when:
1) Its asking price is below its intrinsic value.
2) The potential returns exceed your opportunity cost.
You don’t decide based solely on the numbers. These are just rules of thumb for thinking through the decision.
You’d also have to confirm that all the qualitative and market factors are to your liking.
- What does the internal rate of return (IRR) mean?
The IRR is the “effective compounded interest rate on an investment.”
For example, if you invest $1,000 today and end up with $2,000 after 5 years, the IRR represents the interest rate you’d have to earn on that $1,000 each year to end up with $2,000 in 5 years.
It’s 14.87% in that case, which you can verify with some simple math:
$1,000 * (1 + 14.87%) = $1,148.7, and then $1,148.7 * (1+14.87%) = $1,319.5
And then $1,319.5 * (1+14.87%) = $1,515.7, and $1,515.7 * (1 + 14.87%) = $1,741.1.
Finally, $1,741.1 * (1 + 14.87%) = $2,000.
IRR also represents Discount Rate at which the Net Present Value of an investment equals 0.
- What’s “Net Present Value”?
Net Present Value equals the Present Value of an investment, i.e. the sum of its discounted cash flows, minus the “asking price” – what you pay upfront for the investment.
For example, if the Present Value of an investment is $1,000 and the asking price is $800, then its Net Present Value is $200.
- How do you use IRR?
Normally, you use IRR by comparing it to the Discount Rate, or WACC, of a project, investment, or company.
If IRR exceeds WACC, it makes sense to invest; if it does not, you should not invest.
For example, you estimate a project’s IRR at 12%.
You could invest in other, similar projects and earn 10%.
Therefore, it makes sense to invest in this project because the IRR exceeds your opportunity cost – what you could earn elsewhere.
- What impacts the IRR of a project, investment, or company?
Most of the same factors that impact Present Value: its expected future cash flow and cash flow growth rate, for example.
Your Discount Rate, or opportunity cost, does NOT impact the IRR because you are solving for the Discount Rate when you calculate IRR.
Other factors that influence IRR include the “asking price” of a company or investment and the expected selling price for that company or investment.
- What would make the IRR increase or decrease?
An investment’s IRR might increase if:
- Its expected future cash flows increase
- Its future cash flows are expected to grow at a faster rate
- Its expected selling price in the future increases
- Its “asking price decreases”
An investment’s IRR might decrease if:
- Its expected future cash flows decrease
- Its future cash flows are expected to grow at a slower rate
- Its expected selling price in the future decreases
- Its “asking price” increases.
A company is considering expanding by offering a low-cost airline service in Southeast Asia.
The company’s overall WACC is 11%, but its WACC in this region and industry is 8%. It believes the IRR from this expansion project will be ~10%.
Should it expand into Southeast Asia?
Yes, because you must compare IRR to WACC on a project or department-specific basis.
The WACC of the company as a whole doesn’t matter - what matters is that the IRR in this specific region and division exceeds the WACC for this same region and division.
In real life, you don’t decide just based on the numbers.
- Why is valuation more complex than looking at a company’s cash flows, its cash flow growth rate, and the appropriate Discount Rate?
First off, there are many different types of “cash flow,” and no one can agree on exactly how to calculate it. It also takes quite a bit of effort to move from a company’s financial statements to its cash flow.
Also, the Discount Rate is tricky to estimate correctly, it might change over time, and you may use different Discount Rates depending on the type of cash flow.
It takes quite a bit of work to make a reasonable estimate of a company’s cash flow growth; to do that, you often have to build a more complex financial model.
Finally, “company value” is not so simple.
Are you referring to the company’s value to only the equity investors (shareholders)? Or its value to all the investors in the company? Or something else?
These factors make valuation and financial modeling tricky and time-consuming.
- Why is money worth more today than it is next year?
Because you could invest that money today and earn something with it by next year.
- If there were no inflation, would money today still be worth more than money next year?
Yes, because even with no inflation, you could still invest money today and earn more with it by next year.
- You’re considering renting an apartment by paying a very high deposit, but no monthly rent, or paying a much lower deposit and paying monthly rent.
How can you decide which option is better?
You have to look at your opportunity cost: How much could you earn with the extra money you save by paying a lower deposit?
If you have ideas for high-yielding investments, and you believe you can earn more from them than you’d pay in rent, then it makes sense to choose a lower deposit and monthly rent.
On the other hand, if you have no ideas or your best idea is putting the money in a checking account at the bank, you’re almost certainly better off paying the high deposit and skipping monthly rent.
But to tell for sure, you’d have to run the numbers and compare your estimated investment income to the rental expense.
- Your friend has a new real estate investment idea. He pitches it to you and says it will generate 10% interest per year.
Should you invest in it?
It depends on what your other options are and how the risk of this investment compares to the risk of those other options.
For example, if you could earn 12% elsewhere with the same amount of risk, this opportunity makes no sense.
On the other hand, if you could earn only 7% elsewhere with the same amount of risk, this opportunity makes a lot more sense.
People tend to make the wrong investment decisions because they haven’t properly assessed the risk.
