Discounted Cash Flow – How Much is a Stock Really Worth?
The main idea behind a Discounted Cash Flow model is relatively simple – a stock’s worth is equal to the present value of all its estimated future cash flows. This estimate is also called the “intrinsic value” of the company – its true, internal value.
If the stock is trading for less than its intrinsic value, you have a bargain!
The Discounted Cash Flow model can get pretty complex once you bake in several additional variables to predict future cash flows. We use the simpler version of this model to calculate intrinsic values and make our stock purchasing decisions.
If this sounds like a mouthful of financial talk, don’t sweat it. We’re going to break it down into its elements….
- Estimating future free cash flows Free cash flow is the cash a company has left over after spending the money necessary to keep it growing at its current rate. In other words, Free Cash Flow = Operating Cash Flow – Capital Expenditures To project free cash flow, we need to have an idea of how the company is going to grow – in terms of sales, earnings, expenditures. Studying the financial statements of the company for the past several years and our own understanding of how the company works should give us an idea of these numbers – our best guess.
- Discounting future free cash flows What are these future cash flows worth today? A dollar today is worth more than a dollar ten years from now. Hence, we have to “discount” these future cash flows to their present value(PV). The formula to calculate this is: PV of CF at year N = CF at year N / (1+R)N, where CF = cash flow R = discount rate N = number of years in the future The discount rate is also called the Cost of Capital. It’s really the interest rate the company would have to pay if it were to raise capital from investors. The rate is dictated by risk – a stable, predictable company will have a low cost of capital, while a risky company with unpredictable cash flows will have a higher cost of capital.
- Perpetuity Value How many years in the future do we calculate free cash flows? Usually, we stop after a certain number of years – typically 10. Beyond that, we just lump all future cash flows into a number called “perpetuity value”. The formula is: Perpetuity Value = [CFn x (1+ g) ] / (R – g), where CFn = cash flow in the last individual year estimated (usually yr. 10) g = long-term growth rate – typically estimated at 3{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b} R = discount rate This perpetuity value has to be discounted to its PV PV of perpetuity value = (perpetuity value)/(1+R)^{N}, where R = discount rate N = number of years in the future
- Adding it all up Adding the discounted projections of free cash flow for the time period we chose (10 yrs.) and the discounted perpetuity value, we arrive at the “intrinsic value” of the company. Divide this by the number of outstanding shares, and … voila… we have an estimate of the stock price!
How Good is this Stock Price Estimate?
How accurate is this number? It’s really an estimate based on our projection of the company is going to grow and how future values are discounted to today’s value. That is why we use this number only as a ballpark. We always have to build in a margin of safety to protect us against assumptions we’ve made that might turn out to be wrong.