“When valuing an asset, use the simplest model that you can. If you can value an asset with three inputs, don’t use five. If you can value a company with three years of forecasts, forecasting 10 years of cash flows is asking for trouble. Less is more.”[i]
A dollar today is worth more than a dollar tomorrow, or in Popeye terms, “I’ll gladly pay you Tuesday for a hamburger today” is a raw deal for the hamburger stand owner since technically, the dollar on Tuesday will be worth less.
Three reasons why a dollar or cash flow is worth less than a cash flow today:
1) Inflation … although technically, price growth can flatten out and even reverse into deflation, in general prices increase meaning the same dollar will not buy as much goods. Think of it this way: a box of Rice Krispies cost 16 cents in 1950 and in 2000 it cost $2.99. If you had a dollar in 1950 and held it until 2000, you could have purchased 6.25 boxes in 1950 but only one-third of a box in 2000. Better hope the cashier has a saw blade handy … Snap, Crackle, Pop! This equates to a 95% loss in purchasing power!
2) Folks would just rather consume today; there is just too much uncertainty tomorrow.
3) That dollar tomorrow may never show up. Wimpy has been known to renege on his offers while gorging on boat-loads of hamburgers.
Discounting is the process of converting future dollars or cash flows into today’s dollars using a discount rate. This discount rate takes into consideration the rate of inflation, the consumption preferences and the risks associated with receiving the dollar in the future. (Remember, it might not show up.)
Five types of cash flows exist:
- Simple cash flows
- Annuities
- Growing annuities
- Perpetuities
- Growing perpetuities
It is time to break out your trusty BA II Financial Calculators.
PV = $0
FV = $20,000
I/Y = 10%
N = 10
Posts
No comments:
Post a Comment