Save yourself the fifty million tuition dollars. Here’s everything I learned through one semester at Harvard Business School, summarized in concise, easy-to-read blog format.
FINANCE
1. If you ever find yourself not doing a Discounted Cash Flow (DCF) Model…just remember that you’re wrong.
The DCF is a fancy modelling tool used to project future growth and expectations of a company or a project. In the simplest terms possible: take what you know about a business (we sell ten sodas every year!), add in your estimates for the future (we’ll sell 10% more sodas every year because of how popular we’re getting!), and discount the value of the future cash flows based on how risky you think the idea is or how much/little you value money next year compared to this year (I’m pretty sure people will still like soda next year, so this is low risk). You’ll end up with a number that’s either positive or negative (if, for example, someone said “you can buy the soda business for $100” but you find it only sells $12 worth of sodas), and you’ll want to pick whatever makes money.
It sounds simple, but I promise that the bigwigs in finance have found plenty of ways to make things impossibly complicated. If you want to get serious, you’ll need to do things like figure out how your assets are going to depreciate, how your working capital is going to grow, how your company typically expects returns from its current projects and values for its future cash flows, and more. Still curious? Get started with an Introduction to Present Value at the Khan Academy.
On a more practical note…
2. Everybody’s pretty much just (educated) guessing. Don’t trust things blindly.
So…maybe the cases we discussed in class were oversimplified. And maybe the lesson above is a bit extreme. But the points still stand.
At length, we explored instances where even minuscule differences in estimates had unnervingly large effects on really big decisions. Expecting a Discount Rate (r*) of .09 instead of .085? Suddenly, your business which draws $100,000 in perpetual yearly cash flows is worth $1,111,111 instead of $1,176,470. You just destroyed $65,000 in value because of a whim…or a rounding error.
Worse, perhaps, is the notion of how easy it is to build—even subconsciously—projections and valuations that conform to your own desires and expectations.
Granted, we’re not picking numbers out of a hat. We’ve at least, through hours of careful analysis and years of expensive education, been able to narrow down our field of expectations to something on the order of just over a million dollars. Nonetheless, the lack of true accuracy and transparency, and the subjectivity to error should be quite alarming.
Easy to apply this lesson beyond the finance realm. How much does any expert really know anything? In business, and in life, always exercise reasonable doubt and tread very, very carefully.