30 years: Financial markets trader

After covering compounding and discounting, Abdulla explains how the discounted cash flow can be used to make a rational investment decision.

After covering compounding and discounting, Abdulla explains how the discounted cash flow can be used to make a rational investment decision.

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5 mins 23 secs

Overview

We value an equity stake of a company below by finding the present value of its future cash flows and calculating the net present value based on our initial investment.

Key learning objectives:

Learn how DCF is used to make an investment decision

Understand how investors renegotiate an investment opportunity

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Summary#### How can DCF be used to make an investment decision?

#### How can investors renegotiate an investment opportunity?

Discounting future cash flows can be used to determine the viability of a project. As long as the NPV is 0 or positive, investors should consider it. They will need to know the size of the initial investment, the size and timing of cash flows and the discount rate.

Is a 25% equity stake in a company for £15,000 a good investment?

Using as the basis of the valuation:

- Ten years of free cash flow
- The numbers are accurate and occur on time
- The company has no debt and doesn’t pay a dividend
- Using a 5% discount rate (equivalent to your funding costs)
- Your required annual rate of return is 5% above funding costs
- Your discount rate is 10%

Using the discounting formula, the total PV of earnings comes to roughly £45,000; so a 25% stake is worth £11,326 – resulting in an NPV of -£3,674 (the PV minus the £15,000 investment). An investor should reject the offer.

An investor would be interested if the initial investment was £11,326 because at that level the NPV would be zero and the investors would be earning the required 10% return. Alternatively, by using the DCF formula, an investor can calculate how big a stake would be worth £15,000. The answer is 33.11%.

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Expert### Abdulla Javeri

Abdulla’s career in the financial markets started in 1990 when he entered the trading floor of the London International Financial Futures Exchange, LIFFE, and qualified as a pit trader in equity and equity index options. In 1996, Abdulla became a trainer for regulatory qualifications and then for non-exam courses, primarily covering all major financial products.

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