Full lesson
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Future cash flows, valued today
Cash a company won’t receive for years can still contribute to what it’s worth today, but not dollar for dollar. Forecast cash and later cash are both discounted back to today’s value; discounting accounts for when the cash arrives and the risk in waiting.
Hypothetical cash-flow forecast
This is a hypothetical forecast: the company generates £10 million of free cash flow now, and we assume £10 million at each year-end for years one through three. In year four, cash flow rises to £10.2 million. This is the cash flow path we’ll value.
Chart values
| Period | £m per year |
|---|---|
| Today | 10 |
| Year 1 | 10 |
| Year 2 | 10 |
| Year 3 | 10 |
| Year 4 | 10.2 |
Discount rate: 10% per year
The 10% annual discount rate is the required return used to translate risky future company cash flows into value today.
Three forecast payments, discounted
For each £10 million year-end payment, discount at 10% annually: divide by 1.1 once for year one, twice for year two, and three times for year three. The chart shows present values of £9.09 million, £8.26 million, and £7.51 million. Together, they’re worth £24.87 million today.
Chart values
| Cash-flow year | Present value, £m |
|---|---|
| Year 1 | 9.09 |
| Year 2 | 8.26 |
| Year 3 | 7.51 |
At a ten percent annual discount rate, which payment is worth less today?
Let's think this through. At a ten percent annual discount rate, which payment is worth less today? A: Ten million pounds received at the end of year one. B: Ten million pounds received at the end of year three. C: Both payments have the same present value. Choose an answer, or just think it through. I'll explain in a moment.
- Ten million pounds received at the end of year one
- Ten million pounds received at the end of year three
- Both payments have the same present value
At a ten percent annual discount rate, which payment is worth less today?
The answer is B: Ten million pounds received at the end of year three. The year-three payment is discounted for three years rather than one. Its amount is the same, but waiting longer makes its present value lower.
- Ten million pounds received at the end of year one
- Ten million pounds received at the end of year three
- Both payments have the same present value
Year-three terminal value: £10.2m ÷ (10% − 2%) = £127.5m
Terminal value is later cash flows’ year-three value: £10.2 million divided by ten percent minus two percent, or £127.5 million.
Terminal value also needs discounting
The £127.5 million terminal value is measured at the end of year three, not today. Discounting it back three years at the annual 10% rate gives £95.79 million in present value. That’s the amount that belongs alongside the earlier cash flows.
Chart values
| Valuation date | £m |
|---|---|
| Year 3 | 127.5 |
| Today | 95.79 |
£24.87m + £95.79m = £120.66m
Adding £24.87 million for years one through three to £95.79 million for later cash flows gives an estimated enterprise value of £120.66 million today. Most comes from later cash, so the estimate depends heavily on the terminal growth and discount-rate assumptions. Enterprise value isn’t equity value.
Chart values
| Present-value component | £m |
|---|---|
| Years 1–3 | 24.87 |
| Later cash | 95.79 |
| Enterprise value | 120.66 |
Forecast cash plus later cash, both valued today
Enterprise value is the present value of forecast free cash flows plus the present value of cash flows beyond the forecast. Here, the estimate is £120.66 million, and it changes when cash forecasts, the discount rate, or growth assumptions change.