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:
- How can DCF be used to make an investment decision?
- How can investors renegotiate an investment opportunity?
How can DCF be used to make an investment decision?
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.
How can investors renegotiate an investment opportunity?
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%.