Stock Investing 101 – Discounted Cash Flow

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Discounted Cash Flow

A popular stock valuation approach to discover the fair value of a stock uses a method known as discounted cash flow, or DCF for short.

You see, buying a stock is just like buying a business. You buy a business for the cash it is able to generate and in the case of a stock, earnings per share is what really matters.

Thus, the true value of a stock should reflect the total amount of earnings that company is able to generate over its lifetime. This value then has to be discounted to account for the additional risk of ownership as well as the effects of the time value of money.

While in theory, we should be looking at the free cash flow rather than earnings, but in practice, obtaining the free cash flow can get rather cumbersome and furthermore, both figures approximates to the same value in the long run.

The result obtained will be the fair value of the company which you can then use to assess whether the stock is currently overvalued or undervalued by the market.

For this exercise, we will be looking at a stock XYZ which has a current EPS of $1 and assumed to grow at 15% for the next 5 years and growth to slow to 5% the following 5 years before leveling off thereafter.

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How to Calculate Discounted Cash Flow

Oct 18, 2007 2:58 PM EDT

NEW YORK (TheStreet) — Discounted cash flows are used by pros in the finance world all the time to figure out what an investment is actually worth. And while calculating discounted cash flows can be an involved process, it can also be a lucrative one as well. Here’s a look at DCF valuation and how you can use it on your personal investments and finances.

What Are Discounted Cash Flows?

Think of discounted cash flows this way: they’re a way of taking a payoff from an investment in the future, and putting it in terms of today’s money. Discounted cash flows take into account the time value of money — the fact that one dollar 10 years from now is worth less than $1 today.

If I loan that dollar to someone, I’m costing myself all the interest or gains that I would earn if I saved or invested it. I’m also pitting 10 years of inflation against my dollar’s buying power. What that means is that when all is said and done, my dollar’s only worth around 51 cents (I’ll get to how I calculated that in a bit), which means that I’m losing about half of my money.

Discounted cash flows take these factors into account to calculate what a reasonable valuation is today for a company’s success years down the road.

Why Use Discounted Cash Flows?

DCFs are omnipresent in the finance world — they’re used by everybody, from analysts to portfolio managers — even Warren Buffett is known to make decisions based on discounted cash flow calculations. But why?

Discounted cash flows give investors a better picture of a company’s value

because they account for what it might be worth

. You probably wouldn’t buy a car without knowing what it’s worth, so why would a stock be any different? Having a more relatable dollar value in front of you can help you make better-informed investment decisions.

Discounting can actually be used for more than just cash flows. Historically,

have been discounted because they represent cold hard tangible assets. They’re also devoid of income statement items like depreciation expenses that affect a company’s

without affecting the amount of money the company has.

How Do You Discount Cash Flows?

Word to the wise: discounting cash flows involves math — and a fair amount at that. One of the most basic formulas for discounted cash flows is a present value calculation:

The discount rate mentioned in the formula is the opportunity cost (time value of money) — in the case of my dollar loan, it’s the inflation and lost interest that made my dollar worth so much less 10 years after I lent it. In the case of stocks, the discount rate is typically the cost of the company’s capital.

It gets a little trickier for multiple periods. But never fear, for those of us who aren’t “mathemagicians,” there are a plethora of online calculators (some of which you’ll find in the homework section of this article) that allow you to drop in your numbers in order to calculate the present value of your cash flows.

How to Avoid Common DCF Mistakes

Discounting cash flows can be tricky. Remember, you’re using estimates here for

numbers, so “bad” or unreasonable estimates can mean worthless numbers. According to Jim Troyer, a Principal at The Vanguard Group, these future projections are one of the biggest snags for investors new to DCF. “There are two main things people do,” Troyer says, “make assumptions at random, and project the past into the future.” Troyer describes these mistakes as “blind trend projection” and “inconsistent assumptions.”

Troyer warns investors: “Most firms can’t grow faster than the economy forever. When you use discounted cash flows, it’s important not to project too strong of growth rate too far out. A very small change in something like the discount rate can have a huge affect on present value.”

It’s also important to remember that numbers aren’t static — they change over time. Don’t put too much stock in DCF valuations that might be out of date. A perfectly valid valuation made three years ago might not be at all in line with a company’s present day value.

DCF valuations represent long-term projections, so don’t fall into the trap of thinking that just because a company is supposedly overvalued it isn’t a good short-term investment. Discounting cash flows mainly deals with assessing a company’s fundamentals and doesn’t take into account the technical issues that might send a “bad” stock’s price soaring in the short run.

DCF Methods Vary

The methods used for discounting cash flows can vary depending on the type of investment you’re trying to value. Here are a few popular uses for DCF.

Bonds

. One of the central elements of bond valuation is the use of discounted cash flows. With the bonds, though, the numbers are a lot more concrete. Troyer says, “The bond market is essentially a giant DCF engine. It’s the same way with stocks, but the numbers aren’t as scientific.” Why? With a bond, variables like number of periods, future cash flow, and discount rate (coupon in the case of a bond), are all given and don’t change.

Despite the fact that the discounting of bond cash flows are generally factored into the bond’s pricing, if you’re into

bonds, then understanding DCF is a must.

Stocks

. Stocks are an area where DCF is a popular tool. The stock market is also a place where poorly thought-out DCFs can lose big money.

Stocks have added elements of confusion when it comes to DCF since they don’t have the static numbers that bonds do. Because of this, calculating discounted cash flows for equities adds an extra element of risk that’s actually taken into account in more complex DCF equations.

Real estate

. Real estate is another area where DCF calculations are popular. If you’re a “flipper” (someone who buys properties to quickly fix up and sell for a profit), then you’re doing yourself a major disservice if DCF doesn’t come into your decision-making process.

DCF Recap: My $1 Loan Example

Let’s go back to my $1 loan. How did I determine that 10 years from now I’d only have 51 cents?

Because my friend will be repaying me with $1 in 10 years, the future cash flow to me is just $1.

To determine the discount rate (or rate of return, using a

), I had to consider two things: inflation and the interest I’d be missing out on. With U.S. inflation currently around 2.5% (according to the

C.I.A. World Factbook), and my savings account paying out 4.5%, I’m missing out on 7% annually. That’s my discount rate. We’ll compound annually for simplicity’s sake, which would mean 10 periods. So, taking the equation I showed you earlier, my equation will look something like this:

Granted, this is a very simple example. If you want to learn more complex DCF computations, make sure to check out the homework at the end of this article.

DCF valuation can be a fantastic tool to determine what an investment is worth in

money. But that doesn’t mean that it’s without its pitfalls — bad assumptions and projections can break the benefits of calculating DCF. When used correctly, discounted cash flows can really add a lot to your investment decision process.

DCF Homework

So do you want to get Buffett-like analysis skills? Here are two activities that can help you hone your ability to discount cash flows.

1. Explore Professor Damodaran’s Web site

. If you want to learn more advanced concepts and formulas about discounted cash flows, visit the

. His site on valuation, corporate finance and investment offers lecture notes, tutorials, sample problems and worksheets that can help enhance your valuation abilities.

2. Practice with online calculators

. Go to an online DCF calculator and practice making your own projections for real stocks with historical data. How do your estimates hold up? Here are a few online calculators of varying complexity:

Discounted Cash Flow Valuation: Definition, Investing and Stocks

Dec 13, 2020 3:34 PM EST

A good investor doesn’t work off hunches, but uses proper analysis to make sure that they have adjusted for what’s to come in the future. One of the methods of analysis is to use a discounted cash flow valuation.

What Is Discounted Cash Flow Valuation?

Discounted Cash Flow (DCF) analysis is a method investors use to determine whether an investment is worthwhile by estimating its future returns adjusted for the time value of money. The time value of money — the concept that a given sum of money is worth more now than in the future — discounts projected future free cash flows to arrive at a present value. If the present value is greater than what the investment costs, then the investment is probably a good one.

What Is a Discount Rate?

The discount rate reflects the time value of money and the risk premium, or the additional rate of return investors expect in exchange for taking on risk that they may not receive any cash flow on the investment. The discount rate is also a weighted average cost of capital that reflects the risk of the cash flows — more on that later.

Discounted cash flow analysis is generally accepted in finance as a good way to determine the value of investments that have predictable cash flows like bonds, real estate or a company. The result is only valid depending on how good you are at correctly estimating your future cash flows, however. For instance, if you expect to receive $2,000 rent for an apartment each month and use that cash flow as an input, it will only be correct if your tenant pays you every month.

The discounted cash flow method adds up the series of future cash flows the investment is expected to produce, then converts them into one number that represents the present-day equivalent value of the cash flow: the present value (PV).

The central idea behind the method is the time value of money. To measure how much more money is worth in the present than in the future, one deducts the opportunity cost to waiting for one’s money with a discount rate.

Consider that, in addition to your loss of use if you don’t get your hands on it right away, there’s also inflation gradually eroding your money’s value and purchasing power.

In other words, if you’re going to part with your money for any period of time, you probably expect a larger sum in return than you started with — it’s where the concept of interest comes from. Whether you’re lending or investing, the goal is to make a gain to compensate you for going without your money for a while.

For example, suppose your friend offers to repay you $2,000 today or $2,050 next year. You would weigh whether you’d earn more than $50 over the next year by investing your money elsewhere before choosing to delay receiving payment for that long. Other factors include your time preference (whether you need the money right now or can wait a while to get it back) and whether you trust your friend to actually repay you — another reason why money is worth more in the present: it may never materialize in the future. As the saying goes, “a bird in the hand is worth two in the bush.”

So if you invest your $2,000 with your friend to gain $50 next year, your future value, or the value your investment will grow to in the future, is $2,050. You’re compounding at a 2.5% discount rate.

Likewise, if your friend delays a year in repaying you and only returns the original $2,000, the present value is $1,950 because you didn’t earn interest on it. You’re discounting at the 2.5% discount rate. That $1,950 present value is the value of the future $2,000 payment today.

So in a DCF calculation, you’re taking the expected cashflows of any given investment, then discounting it by the discount rate to find out what it’s worth today.

Discounted Cash Flow of Alternative Investments

What if you could have made more than the $50 your friend is offering for the one-year time period by investing your $2,000 in a risk-free investment like U.S. Treasurys? The appropriate discount rate would be the opportunity cost of capital, a key factor in calculating the discounted cash flow. In this case, it is the rate of return for the comparable investment opportunity with a similar risk profile.

Although there’s no such thing as a 100% risk-free investment, short-term U.S. Treasurys or other stable developed markets’ short sovereign debt are generally seen as having very low risk and are usually the benchmark against which other investment returns are measured, and for a stock or bond investment would serve as a god discount rate.

If you can make more money with a low-risk investment like Treasurys or are willing to take on a little more risk and buy stock in a mature, dividend-paying company with historically stable earnings and free cash flow and low risk of non-payment, that increases the discount rate in that equation. The larger the discount rate is, the bigger the reduction from future value to present value.

For instance, if you are able to make 3% in a short-term treasury, your present value would be $1940 because the opportunity cost is greater.

If you’re looking at stock in a stable, reputable company, the discount rate is higher because they pay a small premium over the safest investments — Treasurys. The additional charge over a risk-free rate investors expect to receive for taking on additional risk is called a risk premium. The greater the risk, the larger the discount rate.

Discounted Cash Flow Valuation for Stocks

As mentioned, discounted cash flow analysis is better as a way to determine the value of investments that have predictable cash flows like bonds, real estate and asset leasing. For stocks, however, DCF presents what Curtis Jensen, former Third Avenue Management chief investment officer, called the “Hubble Telescope problem.” Jensen reportedly said that in equity investing, DCF is like the Hubble Telescope because if you turn it a fraction of an inch you’re in a different galaxy. Even the tiniest changes to growth estimates, growth rates and cost of capital will produce extremely different results.

Another issue with using DCF for valuing stock investments, aside from wide swings in results depending on the investor’s assumptions, is that investors often buy stocks because they believe in the company CEO and her vision, or the company’s “story,” and there’s no room for a story in a DCF valuation analysis. Although a company’s cash flows are important, they can be difficult to predict in large companies where they can be varied and complex. And in short term periods of flux, such as when a corporation is investing in its own growth, cash flow projections may not accurately reflect the stock’s valuation for the long term.

Still, DCF is considered one of the most valuable tools for measuring a company’s performance and future worth. It can reveal truths that P/E ratios and a company’s reported revenue and earnings don’t convey as clearly.

The DCF calculates a company’s intrinsic value based on cash flow projections which are likely to change in time, but the company isn’t as likely to try to distort cash flows the way it may do with earnings, which are more closely watched by shareholders.

Although the DCF valuation is the best metric for long-term investors, it’s based on assumptions that may change suddenly due to macroeconomic conditions and are difficult to predict for longer than a five- to 10-year period.

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