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One of your most important jobs as an investor is to determine whether a stock is overvalued or undervalued so that you can profit from it. One of the most popular methods for assessing the value of a business is discounted cash flow (DCF) analysis. Here’s an overview of how discounted cash flow analysis works and how it can help you increase your portfolio gains.
The short version
- The discounted cash flow (DCF) formula can be a useful way for value-oriented investors to estimate a company’s current value.
- To perform a DCF analysis, you need to know a company’s cash flows and discount rate.
- Combined with other fundamental analysis tools, the DCF model can help investors find undervalued companies that may present strong investment opportunities.
What is cash flow analysis and why is it important?
Discounted cash flow analysis allows you to value a business or investment based on its projected future cash flows. DCF analysis is important because it can help you decide if a stock or financial asset is a good investment.
You can use the DCF model to determine the intrinsic value of an investment. This is investor jargon for the true underlying value of the business. With inherent value and current market value in hand, you can easily decide if you think an investment is overvalued or undervalued. When you choose undervalued stocks, you are setting yourself up for future investment gains.
Private equity firms, Wall Street investment banks, and hedge fund managers rely on DCF models in their analysis and business decisions. If the richest people and companies in the world use this method, it’s probably for a very good reason.
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The DCF model is based on a well-known formula in the world of investment and finance:
FDC = [(CF) ÷ (1 + r)^1] + [(CF) ÷ (1 + r)^2] + [(CF) + (1 + r)^n]
CF means cash flow for a specific future year in this formula. not represents the number of years when calculating multiple years at a time. r is the discount rate.
Before using the DCF formula to perform the analysis, you will need to take a few steps to estimate the future cash flows of the business. Each investor uses their own methods and assumptions to estimate future cash flows. Don’t underestimate the importance of these assumptions and projections — they play a critical role in the calculation.
The discount rate, r, is a measure of business risk and can decide whether an investment should be profitable or not. The discount rate tells you the present value of expected future cash flows.
Where can the discounted cash flow method be used?
The discounted cash flow model helps you evaluate a wide range of investments, including stocks, bonds, funds, and private investments, as well as anything that requires an upfront investment for expected future repayments.
The DCF model is a handy tool for selecting stocks for a typical individual investor’s portfolio. It’s a type of fundamental analysis that helps you determine a company’s intrinsic value, or what you think the company is worth today. If, like Warren Buffett, you’re into value investing, you probably rely heavily on the DCF and similar valuation models.
Business owners and managers can use the DCF model to analyze specific investments. For example, let’s say a local limo company is debating whether or not to buy a new stretch limo. Using a DCF analysis, the business can estimate future limo revenues and costs to determine future cash flows. The DCF model can help the business understand whether capital expenditures will provide an appropriate return.
When deciding between two different investments, you can use the discounted cash flow method to determine which is better. If you have a limited amount of money or working capital to invest, performing several DCF analyzes can help you build the optimal and diversified investment portfolio.
What is the discount rate and why is it important?
The discount rate (not to be confused with the Federal Reserve discount rate) measures a company’s risk and expected return. Very safe investments in stable companies benefit from a low discount rate. Investments in a risky business or startup, on the other hand, would require a higher discount rate.
If you’re not sure what to choose as a discount rate, look at the company’s current interest rate for bonds in the secondary markets. The effective rate of interest on fixed income investments approximates the market risk tolerance and required rate of return for the business.
For example, Twitter sold $700 million worth of bonds in 2019. These bonds were trading at an interest rate of 4.2% at the time of writing. Considering Twitter’s stock, 4.2% might be a reasonable discount rate. Compare that with the ultra-stable IBM, which currently earns around 3.6%, and the slightly riskier Sirius XM, which earns 5%, to get an idea of discount rates for public companies. High risk investments can see discount rates of 20% or more.
A high discount rate results in a lower present value of cash flows. Conversely, a low discount rate leads to a higher present value. This is how you account for the potential of a business not meeting your future cash flow projections.
How do you use discounted cash flows to value a business?
Follow these steps to use DCF to assess a business:
- Collect company financial data. Start by gathering the company’s latest financial information. You can find it through a recent SEC filing, such as a 10K or 10Q, or by using a favorite financial data resource, or perhaps through your brokerage.
- Create estimates for future cash flows. Use a spreadsheet to recreate recent data. Use assumptions about growth trends to build your future cash flow model.
- Choose a discount rate. Then choose your preferred discount rate. Again, you can use the company’s current bond rates as a guideline. However, some investors choose to be more or less aggressive when choosing discount rates based on their investment philosophy and opinion of the company.
- Calculate the present value. Now comes the heavy calculations. But, if you’re good with spreadsheet applications, it’s relatively easy to do the math. They don’t require anything more difficult than what you learned in high school algebra class. Calculation is not necessary!
- Compare with the current stock price. The DCF model should give you the total value of the business. Divide by the number of shares outstanding to get your estimated current value per share.
Savvy investors do not use the DCF model alone. You can choose to use the DCF model in conjunction with market valuation ratios. For example, you can use your DCF calculation for 70% of the price and a combination of ratios for the remaining 30%. Again, each investor has their own preferences and style here. There is no right or wrong answer, just what suits your wallet.
What is a good value for the perpetual growth rate in the discounted cash flow model?
Every business is different, so there is no general guideline to follow regarding perpetual growth rates for the later years of your model. These are represented by the variable n in the formula above.
In general, it’s a good idea to assume that a company’s growth rate will slow down over time. This is because it tries to grow to larger numbers in the future and because it may become more difficult to win new business.
As with the other parts of your cash flow analysis, here you will need to make assumptions to determine the fair value of the business.
One of the fundamental rules of investing is to trust the numbers rather than your instincts. While it’s fun to follow stock advice or your instincts and mimic the trades of the r/wallstreetbets subreddit, it’s better to follow the numbers and data in most cases.
For seasoned investors, this may mean using a discounted cash flow analysis to decide if stocks are worth buying and holding. When you know the numbers, you put yourself in a better position to have many years of successful investing ahead of you.