Warren Buffett's Discounted Future Value of Cash

Welcome to Financial Fluency - a newsletter designed to boost your understanding of financial terms and provide you with investment ideas for long-term financial success.

In today’s newsletter:

• A Look at the Markets: Bitcoin

• Warren Buffett's Discounted Future Value of Cash

• Quote of the Day: Warren Buffett

• What I’m Watching: MoneyWeek

• Word of the Day: Discounted Cash Flow

• Whenever you are ready, here is how I can help you

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A Look at the Markets: Bitcoin

Bitcoin has broken through its all-time highs this week.

I was expecting—and would have preferred, from a technical perspective—a retracement before reaching $108,000. But price action is what it is.

Let’s see if it pulls back to the previous all-time high, around $108,000.

What’s driving this move?

There are likely several factors, but I’d guess that rising global liquidity is playing a major role.

Warren Buffett's Discounted Future Value of Cash

Money Today or Money Tomorrow? The Buffett Approach to Time Value

Recap from Last Week

Last week, we explored the concept of 'intrinsic value' - the real worth of an asset based on fundamental factors rather than market price. We examined how Warren Buffett defines intrinsic value as:

Today, we'll focus specifically on what Buffett means by the 'discounted value of cash' - a crucial concept that has guided his investment decisions for decades and helped build his billions.

Would You Rather...?

Let me ask you a simple question: Would you rather receive €1,000 today or €1,000 in one year's time?

Most people would choose to receive €1,000 today. But why?

1. Inflation - Prices generally rise over time, so €1,000 will likely buy less in one year than it does today

2. Opportunity cost - You could invest the €1,000 today and have more than €1,000 in a year

3. Uncertainty - The future payment carries some risk (Will it definitely arrive next year?)

This preference for receiving money sooner rather than later is the foundation of the 'time value of money' concept.

Simply put: money available today is worth more than the same amount in the future.

But what if I change the question? Would you rather receive €1,000 today or €1,500 in one year?

Now the decision becomes more difficult. Is waiting one year worth an extra €500? This is where the concept of 'discounted future value' comes in.

An Everyday Analogy: The Birthday Gift

Imagine your birthday is coming up, and your uncle has two gift options for you:

1. Give you €1,000 cash on your birthday

2. Put €1,100 in a time-locked safe that you can only open on your next birthday

Which would you prefer? To decide, you'd need to consider what you could do with €1,000 if you received it now.

If you could invest that €1,000 and earn a 15% return over the year, you'd have €1,150 by your next birthday - more than the €1,100 in the safe. In this case, you'd prefer the cash now.

But if your best investment option would only earn 5%, giving you €1,050 after a year, the €1,100 in the safe would be the better choice.

The Discount Rate

The percentage we use to compare present and future money is called the 'discount rate'. It represents:

• The rate of return you could earn on your money elsewhere

• The rate of inflation you expect

• The risk associated with waiting for future money

For example, if you use a 10% discount rate:

• €1,000 one year from now is worth approximately €909 today (€1,000 ÷ 1.10)

• €1,000 two years from now is worth approximately €826 today (€1,000 ÷ 1.10²)

Applying This to Business Valuation

When valuing a business, we need to consider that the cash flows will be received over many years in the future. Each future cash flow must be 'discounted' back to its present value.

Let's look at a simple example:

Imagine a business that is expected to generate the following cash flows:

• Year 1: €10,000

• Year 2: €12,000

• Year 3: €15,000

If we use a discount rate of 10%, we can calculate the present value of these cash flows:

So, the present value of all future cash flows - the intrinsic value of this business according to Buffett's definition - is €30,278.

Warren Buffett's Approach to Discounted Cash Flow

Buffett is famous for his patience and long-term outlook. He understands that businesses can generate cash for decades, and he's willing to wait for those future cash flows.

However, when applying his "discounted value of cash" methodology, he strictly follows these principles:

1. Future cash flows must be discounted to the present value

2. The discount rate should reflect the risk and uncertainty of those future cash flows

3. It's better to be conservative in your estimates

This disciplined approach to calculating the discounted future value of cash is why Buffett often says he looks for businesses with predictable earnings and strong competitive advantages - they have more reliable future cash flows, which means less discounting for risk.

Real-World Application

Let's go back to my motorsport business example from last week. When valuing the business, I had to consider not just the physical assets but also the future profits the business would generate.

If I expected the business to generate €50,000 in profits each year for the next five years, I wouldn't value it at €250,000 (5 × €50,000). Instead, I would discount each year's profits to reflect the time value of money.

Using a 10% discount rate, the present value would be approximately €189,000 - significantly less than €250,000.

Conclusion

Understanding Warren Buffett's approach to the discounted future value of cash is the first crucial step in applying his investment methodology. By recognizing that money has a time value, investors can begin to properly assess the true worth of a business.

However, calculating the discounted value of future cash flows is just part of the story. The real investment decision comes when we compare this intrinsic value to the market price of a business.

Next week, we'll explore this critical comparison with a practical example. We'll take a simple business case, calculate its intrinsic value using Buffett's discounted cash flow method, and then analyse different scenarios where the market price is above or below this value.

This will show us exactly how Buffett uses these calculations to make his actual investment decisions.

Note: Calculating discounted cash flow always requires some assumptions.

Key Terms:

• Time Value of Money: The concept that money available now is worth more than the same amount in the future

• Discount Rate: The rate used to convert future money into present value

• Present Value: The current worth of a future sum of money given a specified rate of return

• Discounted Cash Flow (DCF): Buffett's preferred method for calculating intrinsic value

As always, none of this is financial advice. Everyone should invest according to their personal circumstances, risk tolerance and financial goals.

Quote of the Day: Warren Buffett

What I’m Watching/Reading: MoneyWeek

Word of the Day: Discounted Cash Flow

Discounted cash flow - noun (compound) - a valuation method that calculates the present value of expected future cash flows by reducing them to account for the time value of money.

From "discount" (Old French "desconter" meaning "to deduct") + "cash flow" (the movement of money in and out of a business) - a fundamental analytical tool used by investors to determine the intrinsic value of investments and businesses.

Context and Usage

Discounted cash flow (often abbreviated as DCF) is one of the most important concepts in finance and investment analysis. It forms the mathematical foundation for determining whether an investment is worth making. The method recognises that future money is worth less than present money due to inflation, risk, and opportunity cost. Professional investors, corporate finance teams, and business analysts use DCF models daily to make critical financial decisions.

Common Collocations

Discounted cash flow model - the mathematical framework used for valuation calculations The investment team built a comprehensive discounted cash flow model to evaluate the acquisition target.

Discounted cash flow analysis - the process of applying DCF methodology Before making any major investment, we conduct a thorough discounted cash flow analysis.

Discounted cash flow valuation - the resulting value from DCF calculations The discounted cash flow valuation suggested the company was worth €200 million.

Run a discounted cash flow - to perform DCF calculations The analyst decided to run a discounted cash flow to determine if the stock was fairly priced.

Business Example: The private equity firm's discounted cash flow calculations showed that the manufacturing company was trading at 40% below its intrinsic value, making it an attractive acquisition target.

Buffett Context: Warren Buffett's famous definition of intrinsic value as "the discounted value of cash that can be taken out of a business" demonstrates how central discounted cash flow thinking is to successful long-term investing.

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Disclaimer:

This newsletter is for informational and educational purposes only and should not be construed as financial advice. The information contained herein is generic and does not take into account your individual financial circumstances. You should always consult with a qualified financial professional before making any investment or financial decisions.

Additionally, the authors and/or publishers of this newsletter may hold investments in securities or other financial instruments mentioned herein. These are included for illustrative purposes only and should not be taken as a recommendation to buy or sell such securities or financial instruments.