Discount model part 4: Profit

This article about using the profits of a company for calculating the company value is the final part in this series. Part 1 discusses the general principles and calculation of the discount model. Part 2 and 3 explain the calculation of the company value with the discount model using the cash flow and dividend.

This article discusses the Profit Discount Model, as well as the advantages and disadvantages of this model. Besides that, the differences between the several discount models will be summarized.

Profit Discount Model

The Profit Discount Model uses the yearly profits of a company to calculate the current value of that company. In previous articles it is mentioned that, by using the discount model, future income can be made present. The discount model uses an estimation of future income and calculates the net present value of this income. Using this net present value of all future income, the current value of a company can be calculated.

Profit is the complete yearly income of a company. It does not matter whether the profits are reinvested directly or not (for that years profit). Profits can also be completely or partly redistributed to shareholder by paying dividends or share buybacks. Besides that, profits can be virtual, like profits or losses of revaluing buildings. The profit is thus the total difference between the increase of value and the decrease of value of a company.

Advantages of profit

There are several advantages of using the company's profit to calculate the discount model. The first advantage is that profit is the actual increase of the company's value. Besides that, when the profits increase each year, something must be done right by management.

Profits are, other than cash flow or dividend, the truly increase of value of a company. Profit is not just the increase of cash over the years like the cash flow. Profits also are the paper profits and losses on investment activities, like buildings or joint ventures.

Another advantage is that decisions made by management are taken into account indirectly. Investments in current and new activities are direct choices of management. Management determines the direction of the company for the coming years. These choices impact the result (or profits) directly. Right decisions will increase the profits. Wrong decisions will lower the profits or at least will not make the profits grow. So, the use of profits for the discount model will indirectly take the performance of management into account.

Disadvantages of profit

Besides advantages, there are also disadvantages for using the profits to calculate the net present value of a company. The profit of most companies is different each year. Another disadvantage is that not all affairs can be influenced by the company and that profits contain not structural profits or losses. And finally, different companies will use different types of profit calculations.

Profits of most companies are fluctuating a lot over the years. One year, a very high profit can be made, while the next year the company makes a loss. No single company has the same profit year after year, or increases their profits year after year at the same rate.This is one reason why predicting the profit of a company is very hard.

It is also hard to predict a company's profit because profits are influenced by different affairs. A company can make an extra profit one year by selling some operations or discontinuing a joint venture. This causes the quality of the profit of that year to decline, because it is quite certain that the profit level for next year will be lower.

The final disadvantage is the existence of different types of profit. A company can calculate it's profit before or after taxes or before or after dividends. Below are the most used types of profit calculations described.

EBIT: Earnings Before Interest and Taxes

EBITDA: Income Before Interest, Taxes, Depreciation and Amortisation

PAT: Profit After Taxes

PATD: Profit After Taxes and Dividends

Differences between the methods

Like indicated in the different articles of this series, the calculation of the discount models itself does not differ. The starting point of the different discount models is different.

The cash flow discount model (Discounted Cash Flow) is based on the point of view that true growth of the available money of a company is the most important. Cash flow is seen by a lot of investors as one of the most important indicators for investing in a company. For sure, if a company has a long term negative cash flow, the company will fail in the end.

The dividend discount model is based on the point of view that the income for investors are most important. An investor will earn money out of an investment. Preferably, an investor wants to create a stable yearly income out of its investments, besides the growth of the share. Actually, this is the cash flow of the investor instead of the cash flow of the company.

The point of view of the final discount method (Profit Discount Model) is that the profits of a company are leading. This means that the management is trusted to make the right decisions. Also not only the profits or losses on cash is taken into account, but also the virtual losses on investments,

Each investor can wield a different point of view for him- or herself. Therefore no one right discount method is available. The use of the discount model differs per investor.

Read more about the discount model

In part 1 of this series of articles, the basics and the calculation of the discount model is explained. In part 2 of this series, the cash flow discount model (Discounted Cash Flow) is discussed. In part 3 of this series the dividend discount model is clarified.

You can also use the tool on this website to calculate the net present value.

In this series of articles about the discount model, I discussed the discount model, the different discount methods and the advantages and disadvantages of each method. I also explained the calculation, the origin and other information about the discount model. Leave a comment to let me know what you think about this series!