I was taught, and I believe with all my head and heart, that companies are worth the “present value” of “future cash flows”. What that means is if you could know with certainty the exact amount of cash earnings that the company will produce from now until eternity, you could lay those cash flows out and then using some interest rate that reflects the time value of money, you could calculate what you’d pay today for those future cash flows.
Let’s make it really simple. You want to buy the apartment next to you for investment purposes. It rents for $1000/month. It costs $200/month to maintain. So it produces $800/month of “cash flow”. Let’s leave aside inflation, rent increases, cost increases, etc and assume for this post that it will always produce $800/month of cash flow.
And let’s say that you will accept a 10% annual return on your investment. There are a multitude of reasons why you’ll accept different interest rates for different investments, but we’ll just use 10% for this one.
Once you know the cash flow ($800/month) and the interest rate (also called the “discount rate”), you can calculate present value. And this example is as easy as it gets because the cash flow doesn’t change and the interest rate is 10%.
The annual cash flow is $9,600 (12 x $800) and if you want to earn 10% on your money every year, you can pay $96,000 for the apartment. In order to check the math, let’s calculate 10% of $96,000. That’s $9,600 per year.
In practice, it is never this simple. Cash flows will vary year after year. You’ll have to lay them out in a spreadsheet and do a present value analysis. We’ll do that next week.
But it is the principle here that is important. Companies (and other investments) are worth the “present value” of all the cash you’ll earn from them in the future. You can’t just add up all that cash because a dollar tomorrow (or ten years from now) is worth less than a dollar you have in your pocket. So you need to “discount” the future cash flows by an acceptable rate of interest.