Discounted Cash Flow (DCF) was introduced by Goldman Sachs in 1992 as an attempt to make stock valuation more transparent and improve its accuracy. In the process, it provided investors with a new valuation technique that can be used to price stock investments.
DCF is a financial valuation technique in which discounted cash flow (DCF) is used to estimate a company’s future cash flow. This gives the user the ability to calculate a value that is discounted for any number of known or unknown risks. Because DCF is an estimation, it is often referred to as the “worst-case scenario” or “lowest case scenario”. As with any valuation method, it must be used with caution.
This article explains how the discounted cash flow model (DCF) is used to value assets and the different types of DCF calculations. It also goes into some detail on how to calculate adjusted cash flow at the end of the accounting period and the value of the assets at that point in time.
The discounted cash flow (DCF) method is the best method for calculating net asset value. But why is recoverability necessary? Because it allows you to judge whether or not the action was evaluated correctly. The DCF method is not a simple pricing method. Therefore, financial ratios are typically used to verify price estimates. What are financial ratios? They compare the share price with the fundamental data of the company. The parameters used for the comparison are free cash flow, profit, dividend, book value, sales, etc. The calculation of the coefficients is quick and easy to understand compared to methods like DCF. But it wouldn’t be wrong to say that ratios are just a rough way to evaluate stocks.
- Introduction to discounted cash flows (DCF)
- Concept of the discounted cash flow (DCF) method
- Analogy with exampleabove
- Estimates of future free cash flows (FCF)
- Discount rate
- Use of Terminal Value (TV) instead of FCF
- Example of calculation of net asset value based on the discounted cash flow (DCF) method
- Frequently Asked Questions
Introduction to discounted cash flows (DCF)
DCF is a financial model that estimates the value of the company as a whole. The comparison of the actual value with the share price completes the price estimate. Suppose the shares of the company are trading at Rs 120 per share. We have valued the company based on DCF method at Rs 9000 crore. If there are 100 million shares outstanding, the intrinsic value of the company is Rs 90 per share. Now compare the current price (Rs 120) with the estimated domestic cost (Rs 90). The company’s shares are currently overvalued by Rs 30 crore (33%). This type of analysis is called price estimation. But the difficulty here is in assessing intrinsic value. DCF analysis requires many variables and reasonable assumptions. My stock analysis spreadsheet can calculate the intrinsic value of a stock based on various financial models (including DCF).
Concept of the discounted cash flow (DCF) method
The DCF (discounted cash flow analysis) estimates the net asset value on the basis of future cash flows. The net asset value of a company is the sum of the present value of all future cash flows that it will generate during its lifetime. This statement sounds complicated, but it is. Let me explain this with a simple example. Let’s say you bought shares in a hypothetical ABC Corporation. The project is expected to last only six days. During this period it will generate the following cash flows for itself (net income or free cash flow):
- Day 1: Rs. 100 million
- Day 2: 110 million rupees
- Day 3: Rs. 121 million
- Day 4: Rs. 133
- Day 5: Rs. 146 million
- Day Six: Rs 450
What would be the intrinsic value of an ABC company? This is the sum of all free cash flows generated during six days. Embedded value = 100+110+121+133+146+450 = Rs. 1,060 million.
Analogy with exampleabove
The above example seems too simple, doesn’t it? Yes, because it’s a hypothetical. In the real world, the lifespan of a business is much longer. As a result, forecasts of future free cash flows can become complex and inaccurate. This is the main obstacle. Similarly, adding up all cash flows for future years would not be correct. We need to calculate their present value (PV). To calculate the PV, we need a number called the discount rate. This is now the second major obstacle. The accuracy of the discount rate is important in estimating the intrinsic value. Thus, to accurately apply the DCF method, we must first learn to estimate future free cash flows. Second, we need to know what discount rate to use to calculate present value.
To simplify things, I will give another hypothetical example. But this time the presentation will be a little more realistic. Suppose you have purchased shares of a hypothetical company ABCD. The company will exist for six years. During this period it will generate for itself the following cash (net income or free cash flow):
- Year 1: Rs. 100 million
- Second year: 110 million rupees.
- Third year: 121 million rupees
- Fourth year: Rs. 133
- The fifth year: 146 million rupees
- Grade 6: Rs 450
We also accept a discount rate of 9% per annum. What would be the intrinsic value? It is the sum of the present value (PV) of all free cash flows generated during the six years of the company’s existence. In terms of a mathematical formula, the ticket would look like this. The intrinsic value of ABCD will be : Embedded value = PV(100)+PV(110)+PV(121)+PV(133)+PV(146)+PV(450) = 100 / (1+9%)^1 + 110 / (1+9%)^2 + 121 / (1+9%)^3 + 133 / (1+9%)^4 + 146 / (1+9%)^5 + 450 / (1+9%)^6 = rubles. 735.193 Crater The company, which as mentioned above has generated a cash flow of Rs. 100-450 million, will generate an intrinsic value of Rs. 735.2 million. The first hurdle in the DCF analysis is the estimation of the future free cash flows. So let’s try to figure out how to evaluate it.
Estimates of future free cash flows (FCF)
What is free cash flow (FCF)?
FCF is net cash flow from operating activities less capital expenditure (CAPEX). As for the formula, there are two alternative ways to express the FCF: View free DCF calculator With the DCF method, the correct estimation of all future free cash flows has the highest priority. But since we are talking about the FUTURE, we can only guess and speculate about the future of FCF. What is the best way for me to judge? The first step is to calculate the historical FCF (5 years). Using FCF, we will analyze the dynamics of the following two indicators. Try to understand whether these two variables will improve, worsen or remain stable in the future.
- The competitive advantage of the industry.
- The economic moat of the company.
In general, a company with a strong economic position can continue to grow at the same rate as in the past. However, it needs support for the economy and the sector. An improvement and growth in the economy could lead to a further increase in the FCF. Similarly, if the company is in a growth sector (industry).
Why do we need discount rates? The present value of future free cash flows must be calculated. Why do we need real values? To learn more, read about the concept of the time value of money. In this article, I will provide a simple example for quick understanding. The concept is that money loses its value over time. 100 rupees in our pocket today is worth more than 100 rupees in a year. Why? Because inflation reduces the purchasing power of money. Suppose your father has decided to give you a gift of Rs. 5,000. But it offers you two alternatives. 1 : You can take 5,000 rupees today. Secondly, you can get Rs 6,050 billion in two years from today. Which option is best for you? To answer this question, we will use the concept of the present value of money. But before applying the present value concept, a discount rate must be chosen:
- Inflation rate : You know the current inflation rate is 7% per year. Use this number to calculate the current value in rupees. 6 050. The cost is Rs 5,284 (= 6050 / (1+7%)^2). This means that the present value of Rs. 6,050 is equal to Rs. 5,284 today. If you accept the gift today, you will get only 5,000 rupees. But accepting the same gift after two years is equivalent to accepting Rs 5,284 billion today. Therefore, the second option would be more advantageous.
- Return on investment: You know of an investment opportunity that can give you a 15% annual return if you hold it for two years. Now take 15% as the discount rate and do the math. The present value of Rs. 6,050 is Rs. 4,575 (= Rs. 6050 / (1+15%)^2). In this case, the first option is preferable. [Logic: Invest your gift today at an annual interest rate of 15%. After 2 years it will be 6,612 billion rupees [5,000 * (1+15%)^2)].
We can use the same analogy to choose the discount rate in our equity analysis.
- The first option is to choose a weighted average cost of capital (WACC) that is comparable to inflation.
- The second solution is to first think internally about the type of return you want to achieve. Let’s assume this value is 18% per year. We can then use 18% as the discount rate.
However, experts insist on the WACC method. If you want to know more about the calculation of the WACC, see the link above.
Use of Terminal Value (TV) instead of FCF
In financial jargon, TV is also called perpetual value. As the name suggests, we assume that this company will always be active. But there is a problem with this theory. How can you predict the total FCF of a company if it goes on forever? In general, forecasting the FCF over the next five years is a challenge in itself. So if a company has an open-ended nature, how can you predict its total FCF? It seems almost impossible, doesn’t it? That is why the concept of finite or eternal value appears here. How does it work? FCF projections for the next five years. Then estimate the lump sum value of all free cash flows occurring after the fifth year. We call it a one-time cost of television or perpetual value. The formula for calculating the cost of the terminal is shown below: After incorporating the concept of terminal value (TV), the formula for the intrinsic value of a firm is as follows:
Example of calculation of net asset value based on the discounted cash flow (DCF) method
Suppose you have purchased shares of a hypothetical company ABCD. The company will exist for six years. During this period it will generate for itself the following cash (net income or free cash flow):
- Year 1: Rs. 100 million
- Second year: 110 million rupees.
- Third year: 121 million rupees
- Fourth year: Rs. 133
- The fifth year: 146 million rupees
- Discount rate (r) : We have two choices. We can either calculate the firm’s WACC or apply the theory of expected return (see here). For simplicity, we will use the number of expected returns as the discount rate. Suppose the interest rate on the loan is 9%.
- Undetermined growth rate (g) : If you take this number as a stock, be careful. The higher the number, the better. But it is also important to understand that this is the average growth rate at which the company will develop during its existence. Historically, it is difficult for even the best companies to outperform inflation when the time horizon is eternal (very eternal). For a country like India, the long-term inflation rate is 5% per year. We are therefore assuming a growth rate of 5% and no more.
Now apply the intrinsic-value formula using the numbers and assumptions above: The intrinsic value of the entire company is Rs. 4,299.4 million. Assuming a company has 100,000 shares in the market, the net asset value per share would be Rs. 42.99. If the current price of ABCD is above Rs 42.99, it means that the stock is overvalued.
Display the value of terminal
Of the total estimated value of the company (Rs 4,299.4 million), the terminal value (Rs 3,832.5 million) represents 89%. The following three factors affect the cost of the terminal:
- FCF 5 years. The FCF calculation for the fifth year is correct only if the FCF calculation for the current year is correct. In addition, the growth rate of the FCF in the first five years is also critical. A value that is too high or too low has a significant impact on the ultimate intrinsic value.
- The higher the discount rate (r), the lower the intrinsic value. I am a defensive investor, so I prefer a higher discount rate for my stocks.
- A high perpetual growth rate (g) guarantees a high intrinsic value. But I prefer a more defensive number. Choosing a growth rate of 5% or less for my shares seems more logical (why? read here).
Calculating the net asset value of a share using the DCF model is not easy for everyone. But it is also true that the DCF method is one of the best ways to estimate the intrinsic value of a stock. But as you have seen, estimating intrinsic value with DCF involves several steps. In addition, a deeper understanding of management accounting is required. This procedure is impeccable, but it has its limitations.
The most important thing is that the investor understands the numbers in the financial statements. I have developed a method for myself. I call it a stock analysis worksheet. This MS EXCEL spreadsheet can estimate the intrinsic value of my shares based on the DCF method and other methods. One thing that is constant in investing is the need to find the right balance between investment risk, return, and time.
Usually, you want the return to be higher than the risk, but if the return is higher than the risk, the time can drag on. In a lower-risk investment like stocks, this can be the case, and perhaps that is why discounting cash flow is considered so important. Read more about dcf stock valuation example and let us know what you think.
Frequently Asked Questions
How do you do a discounted cash flow?
DCF is one of the most common methods used to value companies. Its key steps are to calculate the company’s free cash flow (FCF), discount that cash flow to the present (using the appropriate discount rates), and then value the company using the Present Value of the Future Cash Flows (PV-FCF). A discounted cash flow (DCF) model is used to estimate the value of a company. The DCF is a calculation of a company’s net cash flow (after royalties and taxes) that can be used to estimate the value of the company.
How do you calculate cash flow from stock?
Stock valuation is the art of predicting an asset’s future value based on its current market price. When a financial analyst starts working on a company valuation, he or she will generally use one of two valuation methods, discounted cash flow (DCF) and relative valuation. One of the most important tasks for investors is to estimate a company’s future cash flows. The most common way to do this is with a discounted cash flow analysis.
How does a discounted cash flow work?
A discounted cash flow (DCF) is a process of estimating the future cash flows of a company, which is especially useful in helping companies decide whether their assets are under- or overvalued. This is actually the opposite of a discounted cash flow valuation, which is where you take an undervalued company and estimate how much money it will be worth in the future using past cash flows.
The key difference between the two methods is that in the DCF method, the value of the company is calculated based on the discounted cash flows, which is why the name “discounted cash flow”. The discounted cash flow (DCF) method is used to determine the value of a company by looking at the future cash flows a company can generate.
The premise is pretty simple: You start with the present value of future cash flows and subtract any initial investment in the company. The result is the book value of the company. The basic idea behind discounted cash flow is that the company’s future cash flows will be discounted for the time value of money. Thus, the present value of all future cash flows is more valuable than the present value of the initial investment.
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