The final stage of financial statement analysis converts what has already been learned from the first three steps – industry and business analysis, accounting analysis, and ratio analysis – into forecasts of future benefits. This note shows how to convert such forecasts into estimates of value.
The key question to ask whenever we think of investing is how much the right to a future stream of benefits from the investment is worth to us today.1 This value is a function of the magnitude, timing, and uncertainty of these future benefits.
By magnitude we mean that, all else being equal, the greater the benefit (whether we define it as “cash flow” or something else), the better. Timing means that we would rather have the benefit now than have to wait for it. For example, the earlier we expect to receive a cash flow, the more valuable that cash flow is to us today. Uncertainty refers to the possibility that the expected benefits might not materialize. Intuitively, the greater this uncertainty, the less valuable an expected benefit is to us now.
These insights are captured in the discounted cash flow (DCF) approach to valuation. With this approach, we project expected future cash flows (magnitude and timing), then discount them at an interest rate, or rate or return. The discount rate reflects both the time value of money (i.e., the idea that investors would rather have cash today than tomorrow and must ...