DCF Analysis – an example - II

This is part II of the article DCF Analysis – an example. Please read the article from the first part before continuing with this one

Start Date	01-Jan-05	Investment Period		3 years
End Date	31-Dec-07	Interest Rate		9%	Present Value of
A	B	C	D	E	F	G
Date	Stock	Buy	Sold	Annualized time	PV-Buy	PV-Sold
01-Jan-05	Microsoft	(1,000.00)		-	(1,000.00)	-
03-Mar-05	GS	(200.00)		0.17	(197.14)	-
01-Dec-05	Google	(4,000.00)		0.92	(3,696.68)	-
10-Feb-06	Microsoft		1,200.00	1.11	-	1,090.57
11-Jul-06	Exxon	(5,000.00)		1.52	(4,384.89)	-
13-Sep-06	Amazon	(2,000.00)		1.70	(1,727.65)	-
19-Sep-06	AMX	(3,000.00)		1.72	(2,587.81)	-
28-Dec-06	GS		600.00	1.99	-	505.49
05-Jan-07	AMX		3,600.00	2.01	-	3,027.19
09-Jun-07	Google	(5,000.00)		2.44	(4,053.34)	-
10-Oct-07	Google		12,000.00	2.77	-	9,449.58
11-Oct-07	Exxon		5,500.00	2.78	-	4,330.03
31-Dec-07	Amazon		2,100.00	3.00	-	1,621.97
Total		(20,200.00)	25,000.00		(17,647.52)	20,024.82
Net (Sold-Buy)			4,800.00			2,377.31

Column A contains Dates, B contains Stocks that we buy/sell, C contains amount invested when we BUY the particular stock, D contains amount we receive when we sell a particular stock. For the moment, let’s ignore the columns E to G.

Now, if we take a simple plus and minus game, then we observe that the net TOTAL amount of money we invested is 20,200 and the net TOTAL amount of money we received from selling is 25,000. Hence, our profit is 25,000 – 20,200 = 4,800. So in terms of % calculations, we have (25,000 – 20,200)/20,200 = 23.76% profit. Very good performance!

However, what we have ignored is that our total investment was split over a period of 3 years and at any given time, we did not invest the total 20,200. Instead, the money we invested was also split in smaller amounts. So what we are ignoring here is the time value of money.

Now let’s take the time value of money into consideration and make some realistic calculations – columns E to G.

The way DCF or discounted cash flow works is explained very well in this article on Wikipedia. Do read it before proceeding further with this article, and it will give you a clear picture of DCF and the mathematics involved.

So, for every amount we spend or receive in the table above, we make the PRESENT Value calculation (using the below formula):

Present Value = (Net Amount Received or Spent / ((1 + interest rate) ^ annualized time)

Annualized time is calculated with respect to your start date – which in this case is 1-Jan-05.

So, for item no. 3 in the table, i.e. Google BUY of 4,000, the date is 01-Dec-05.

Annualized time = (No. of days from 01-Jan-05 to 01-Dec-05) / 365

= 334 / 365

= 0.92

Hence, the present value of our investment of 4000 is calculated as

PV = Amount / ((1 + interest rate) ^ Annualized Time)

= - 4000 / (1 + 9%) ^ 0.92

= - 3696.68 (as mentioned in column F in the table)

Similarly, we do the PV calculations for all the remaining items in the table (columns F and G) and at the end SUM them up together.

We see that the net PV of our BUYS is - 17,647.52 and all SELLS is + 20,042.82.

Hence, the NET value that we get is 20042.82 – 17647.52 = 2,377.81

In terms of percentage = 2377.81/20042 = 13.47%

Therefore, what appeared to be a profit of 4,800 by simple plus/minus calculations (and a 23.76% return), is actually only 2377.81 (and a % return of 13.47% only).

Continue to Part III