DCF Analysis – an example - III

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

This return of 13.47% was accumulated over a 3 year period. Hence, to make a comparison, we should annualize it.

To understand how annualization works, take this example.
You invest an amount of 100 for 3 years at the rate of 10% and don’t withdraw anything in between. How much money will you get at the end of 3 years?

First year principle = 100
Your first year income = 100 * (1+ interest rate) = 100 *(1+10%) = 110
Second Principle = First year principle + First year interest income = 110
Second year income = 110 *(1 +10%) = 121
Third year principle = second year principle + second year income = 121
Third year income = 121 * (1+10%) = 133.10

Hence, at the end of 3 years, you get a total of 133.1
Actually, the simple way to calculate this is the following formula:
Final Value = Initial Principle * (1+ annual interest rate) ^ no. of years
= 100 * (1+10%) ^3
= 133.10

Hence, if we know final value, then we can calculate the effective annual interest rate in reverse calculation as follows:

Final Value = Initial Principle * (1+ annual interest rate) ^ no. of years
So annual interest rate = (Final Value/Initial Principle) ^ (no. of years) – 1

Now, for 13.47%, the annual interest rate comes out to be 4.3% only.
To cross-check : 100 * (1 + 4.3%) = 113.467 = 13.46%, which matches the value exactly.

On the other hand, for simple plus-minus calculations, we received a profit of 23.76%. Corresponding calculations give an annualized return of 7.36% - which is incorrect as compared to the correct figure of only 4.3%.


Hence, if you take the realistic time value calculations, you will observe that the simple plus minus calculation will always give a highly bloated and incorrect value for profit calculations. We MUST understand this very clearly.

---Modified after comment from Nilesh-----
The reason why I gave a detailed example here was because the 4.3% annual return that you are actually generating on your RISKY stock market returns (over and above the risk free rate of 9%), is this extra percentage justifiable with respect to what is offered by the RISK FREE bank accounts or bonds?

Secondly, We have considered all the investments with POSITIVE RETURNS. Not a single stock investment has been assumed to give negative or loss making returns. The moment we take negative returns even for 1 or 2 stocks, the 4.3% will come down drastically.

Thirdly, this article is not only to compare your returns with those Bank accounts and bonds, but to actually learn to compute the right way of profit/loss.
---Modification Ends -----

That is why I always insist on making correct calculations and then see what you have done in the past, what your positions are in the present and would you be interested in avoiding these mistakes for the future.

Tomorrow, I’ll continue with some more parts of options trading tutorial.

Have questions, please read the comments and post your views and queries in the comments section which helps in open discussion and avoids duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.