Education > Analysis > Cash Flow Valuation
Cash Flow Valuation
Many people who start a web site that ends up making money and wants to sell the site don't know how to value the site. The first thing you need to know is that since the values of most assets stem from streams of their expected cash flows, all such assets are valued in essentially the same way, includiung bonds, stocks, lottery winnings, structured legal setlements, businesses, and even web sites. To learn how to value cash flows we will have to go over some very basic financial concepts. For those who are having calculus flashbacks, don't worry, I'll make this as easy as possible. The following explanation is pretty in depth though and if you don't have a pretty valuable site then you won't ned to know all this. All of the examples below assume you get paid at the end of the year.Present Value and future value
A dollar in your hand today is worth more than a dollar to be received in the future because if you had it now, you could invest it, earn interest, and end up with more than one dollar in the future. An example would be if you had $100 today and invested it at 5% then you would have $105 in a year. The present value (PV) is $100 and the future value (FV) is $105 and the interest rate (i) would be 5%. Next, I'll show you how to figure out one value when you have the other.Compounding - finding future value
The process of going from todays value (PV) to tommorow's value (FV) is called compounding. Expanding on the example above, if someone started with $100 and invested it at 5% and had $105 at the end of year 1, then he could take that $105 and invest it at 5% again and could make an extra $10.25 ($105 times 5%) during year 2 and would have a total of $110.25. Fortunately, you don't have to figure out the profits one year at a time, you can figure out the compounded future value by using the following formula:|
FV = PV*(1+i)n where: FV = future value. PV = present value. i = interest rate. n = numer of years. |
Example: The future value of $5,000 if invested for 7 years at 4% is $6,579.66.
Explanation: $5,000 times (1.04)7=$6,579.66.
Discounting - Finding Present Values
Finding present values is called discounting, and it simply the reverse of compounding (If you know the present value, you can compound to find the future value, while if you know the future value, you can discount to find the present value. Compounding and discounting are recipricals of one another.) To find the present value of a future amount of money just plug in the future value, interest rate, and number of years into the following formula, which is just an adjusted version of the compounding formula:| PV = FV / (1+i)n |
Example. The present value of $10,000 received 4 years from now, assuming a rate of 5% would be $8,227.02.
Explanation: ($10,000)/(1.05)4.
Cash Flow Valuation
Now, since we just learned how to take a one-time cash payment in the future and figure out what it is worth today, all we have to do to value a cash flow is to take all the payments you will receive in the future (each payment's future value) and discount each payment to find their present value and add them up.How to value cash flow - finite cash flow
- EVEN CASH FLOW
My first example would be to find the present value of a series of equal payments made for a specific numer of years (this is also called an annuity). In the following example you will receive a cash flow of $1,000 for 4 years. To figure out the PV of the $4,000, you will want to take the first year's $1,000 and discount it for 1 year at 5%. Then take the second $1,000 and discount it for 2 years at 5%, etc.
- UNEVEN CASH FLOW
My second example is to find the future value of an uneven cash flow stream. This is called a terminal value. In this example, you will do this the same as the example above - there is no real difference here.
How to value cash flow - infinite cash flow with no growth
You will want to know how to figure out the present value of a cash flow that goes into the future for infinity. This is called a perpetuity. Theoretically, this is how some stocks (like large, stable companies like GE) are valued because people assume that companies like GE won't ever go out of business so their business is basically an infinite stream of cash flow (their dividends). The further you go into the future each dividend has a smaller present value then the preceeding one because it is being discounted more. In fact, if you far enouh into the future the present value of the future dividends eventually gets close to zero. Because of this the profits way out in the future actually contribute very little to the present value.When it comes to valueing small and medium web sites it would probably be an error to assume your web site would go on forever into the future but this formula is still very useful if you assume you web page will be profitable for the forseeable future (10-20 years). Fortunately, when you have an infinite stream of equal cash flows you don't have to add up the present value of all the individual years because the present value of all those future cash flows conveniently equates to the following formula:
| PV (perpetuity) = Cash flow / interest rate |
How to value cash flow - infinite cash flow with fixed growth
Sometimes you will have an asset that has a certain cash flow and is expected to grow at x% into the future. One example would be a stock of a large company (like Gillette) that is expected to grow at 3% forever. Another example would be a web site you have that has basically saturated the market but you expect the site to grow at 3% per year into the future based just on general internet growth. Here the formula for this scenario:|
PV = Cash flow / (interest rate - growth rate) where: g=constant rate of growth |
How to value cash flow - infinite cash flow with uneven growth
The most likely scenario would be that you have a web page that will have a web page that will have high growth for a few years and that growth rate will eventually become very low. To figure out the value of the web site you will calculate values of the 2 different parts. The first is the individual present values of the cash flow during the high-growth years. The second part of the calculation is figuring out the present value of the cash flow stream when the growth declines to a constant number.The following example shows an example of a web site that makes $20,000 the first year and is assumed to grow at a rate of 20% for 2 years then after that the site will grow 3% each year into the future. The present value of the cash flow is equal to $1,548,894.
In this case you can see we calculate the present value of each of the first 3 years and come up with $19,047.62, $21,768.71, and $24,878.52.
The second part of the calculation is the stream of cash flow that begins when the 3% growth rate begins. We then value this portion like we did in the last example - as an infinite cash flow with constant growth. In this case, we take the cash flow for year 4 with a value of $29,664 as the starting point for the infinite cash flow. We then calculate the present value and come up with a value of $1,483,200.00 ($29664/(.05-.03)). Now, this is the value of that infinite cash flow at the beginning of year 4. But we want to find the present value of that cash flow today so we have to discount the $1,483,200.00 further for 3 years at 5%. Therefore, the present value of that $1,483,200.00 3 years form now is $1,281,243.93 (explanation: $1,483,200.00/.05).
We then add up all of the calculations. It is easier to look at the graph.
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