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Media Industry

The complexity of discounted cash flow

Folio: The Magazine for Magazine Management, Sept, 1985 by Richard M. Koff

You have seen many articles in these pages about the various methods used to evaluate magazines. They include price/earnings multiples, multiples of annual sales, net worth, assigned value per subscription, and, best of all, the present value of a future stream of earnings--also known as the discounted cashflow method.

At first glance, discounted cash-flow (DCF) is a straightforward and reliable measure of any investment opportunity: You estimate the cashflow to be derived from the investment for five to 10 years into the future, apply a discount rate to the future stream of cash to establish a present value--and that's what the magazine is worth today, period.

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But the two elements in this calculation are fraught with complexity. Estimating cashflow for five to 10 years into the future means making hundreds of assumptions about advertising rates and pages sold, subscription prices and response rates, newsstand prices, draws and sellthroughs, paper and printing costs, editorial and promotion costs, and so on. You make these assumptions, plug them into a computer model--and out comes cashflow on a month-by-month basis in neat and authoritative tables.

The trouble is that the computer printout is seductively precise looking; it masks the fact that the numbers are entirely dependent on the accuracy of your assumptions--assumptions that are, at best, informed estimates, and at worst, wild guesses.

But let's say you used good numbers and the optimistic assumptions were compensated for by the pessimistic ones so that, on the whole, the projected cashflows represent a conservative estimate that feels about right. You must now decide on a discount rate that will establish the present value of this future stream of cash.

You will remember the essential facts about compound interest--$1,000 today is worth $1,100 one year from today if the money has been invested in a money-market fund paying 10 percent per year. Thus there is an exact equivalence between the $1,100 next year and $1,000 today. A similar calculation can be applied to cash earned two, three, four or five years in the future to find its equivalent value today. When you add all the present values of those future cashflows, you have a number that represents the entire future stream.

A money-market fund is essentially risk free--it is backed by the bank and the U.S. Government. A magazine's future cashflow, as we have seen, is a much less reliable investment, so an investor will want to apply a higher discount rate to the magazine's earnings. I have seen publishers use 20 percent, 30 percent and even 40 percent rates when considering an acquisition--a range of choice that can have a very substantial effect on the present value, as shown in Table 1.

In Table 1, the cashflow is patterned after a magazine that has passed its break-even point and promises to show substantial growth in profits up to $500,000 a year when it levels off. The magazine is sold for $2,000,000 at the end of the tenth year. Note that at the higher discount rates, the contribution of the later cashflows quickly approaches negligible values. At the 40 percent discount rate, the $500,000 in year nine contributes only $24,000 to the present value, and the entire $2,500,000 in year 10 adds only $86,000 to the present value.

Table 1 suggests that a magazine like this one with a cumulated cashflow of $6,000,000 may be valued at anything from $3,013,000 to $738,000, depending on the discount rate. That's a wide spread, so let's take a close look at the discount rate and see if we can narrow the choice somewhat.

There are actually three components to the discount rate. The first, as we have mentioned, is the risk-free return. Clearly, any magazine must earn at least what an investor could get if the money were placed in a risk-free investment of some kind. To be applicable to our discounted cashflow calculation, we must use as the risk-free return the interest offered by a long-term investment such as 10-year government bonds, which are paying around 12 percent right now.

Consider inflation

Second, an investment must take into account inflation in the value of the dollars. Because the government bond is paid off in future (i.e., inflated) dollars, its 12 percent interest rate already includes inflation. The "real" interest rate is less than 7 percent if inflation in the value of the dollars is a flat 5 percent over the 10-year term. (To be precise, it is 1.12/1.05=1.0667, or 6.67 percent.) If the projections of cashflow for our magazine use future advertising and circulation prices, and estimates of future costs, the cashflows are in future, inflated, dollars.

Finally, an investment in a magazine will be expected to earn a premium over the risk-free rates offered by government bonds because of the greater risk the investment entails. There are several methods used by financial theorists to estimate the risk of an investment. The most popular one measures risk in terms of the volatility of a given stock in comparison to that of one of the larger market indices such as Standard & Poor's. Thus, if a given stock is found to be half again as volatile as the S&P index, its riskiness (called beta in the literature) is 1.5. If it is twice as volatile, its beta is 2.0. The problem for us is that our magazine is probably not traded on a stock exchange--making an estimate of volatility entirely guesswork.

Media Industry

The complexity of discounted cash flow

Folio: The Magazine for Magazine Management, Sept, 1985 by Richard M. Koff

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