Merchant Portfolio Valuation: Understanding Discounted Cash Flow Analysis (Part I)
Part I: The Time Value of Money
One of the more advanced methodologies employed in determining the valuations of merchant portfolios and merchant processing residual streams is the Discounted Cash Flow (DCF) analysis. A DCF analysis provides both buyers and sellers with a quantitative perspective to the valuation of these types of payments properties and is commonly used throughout the finance community to value many other classes of assets. As a central concept in finance theory, a DCF analysis may appear complicated at first blush, but it’s hardly rocket science. Once you have a firm foundational understanding of the basic concepts incorporated into DCF analysis, it becomes a very manageable methodology.
Let’s take a closer look, beginning with the most fundamental idea behind DCF analysis, the Time Value of Money (TVM).
There are a number of different components of DCF analysis and each of the next few blog posts in this series will be dedicated to breaking these down into more digestible notions. First however, one must grasp the concept of the Time Value of Money. The online resource Investopedia defines TVM as, “The idea that money available at the present time is worth more than the same amount in the future due to potential earning capacity” (www.investopedia.com/terms/t/timevalueofmoney.asp). Another way to think of this idea is that because money obtained at the present moment can earn interest, the same dollar amount of money will always be worth more when received sooner than later. Lets look at a couple of examples:
1) Simple Example: If you were given $100 today and deposited that money into a savings account where the money earned 5% interest per year, $100 invested today would be worth $105 one year from now (the mathematical expression of this would be: $100 x 1.05). If you were given this $100 one year from now, this money would only be worth $95.24 in today’s dollars. This is because you are discounting that $100 at 5% per year (mathematically: $100/1.05) to account for the interest you would have earned had you deposited the $100 today.
2) Applied Example: Now say you own a merchant processing residual stream that is expected to pay you $1000 per year for the next 5 years (with an assumed attrition rate of 0%). You still have the savings account in the previous example that pays an interest rate of 5% per year (this is called your cost of capital, or the money you could be earning otherwise, a concept that will be explained further in Part III of this series). How much would this $1000 residual stream be worth today? Someone who didn’t understand TVM (and obviously doesn’t read this blog) might be inclined to say $5000. The right answer is actually $4,329.48; the residual of $1000 per year was discounted at a rate of 5% per year over the 5 year period.
Example 2 highlights the essence of DCF analysis: $1 today is worth more than $1 tomorrow. And therein lies the key to buyers and sellers of merchant portfolios and residual streams being able to properly value the future cash flows of these properties.
In the next part of this blog series, we’ll discuss and explain how to predict/project merchant portfolio and residual stream cash flows. Meanwhile, feel free to contact one of our portfolio experts for more information.