A beginner’s guide to Discounted Cash Flow (DCF) method for stock valuation

Stock market analysts use this method to find the intrinsic value of a stock

By Muhammad Raafay Khan

As the Pakistani stock market continues to capture headlines with its ups and downs (mostly downs), investors, who prefer to understand their investments instead of doing mere speculation, are always on the lookout for reliable methods to evaluate stocks.

One such method is the Discounted Cash Flow (DCF) valuation method, which has gained popularity in recent years due to its ability to provide a detailed analysis of a company’s financial health and future prospects.

The DCF valuation method is based on the principle that the value of an asset, such as a stock, is equal to the present value of its expected future cash flows. While the DCF method has its advantages, including its ability to provide a detailed analysis of a company’s financial health, it also has its limitations. Critics argue that the method is highly sensitive to small changes in assumptions and can be difficult to use for companies with unstable or unpredictable cash flows.

In this article, we will delve deeper into the DCF valuation method, its advantages and limitations, and explore how investors can use it to make informed decisions about stock investments.

Advantages of DCF

The Discounted Cash Flow (DCF) valuation method is a popular and widely used technique to evaluate the intrinsic value of a company’s stock.

Here are some of the advantages of using the DCF method:

1. Focus on Future Cash Flows: The DCF method focuses on estimating future cash flows of the company, which is a crucial factor in determining the true value of the company. By taking into account the expected future cash flows, this method provides a comprehensive view of a company’s financial health and prospects.

2. Incorporates Time Value of Money: The DCF method takes into account the time value of money, which means that it considers the idea that money today is worth more than the same amount of money in the future. By discounting future cash flows back to their present value, the DCF method provides a more accurate and realistic valuation of a company’s stock.

3. Flexibility: The DCF method is flexible and can be applied to a variety of companies across different industries. It can also be used to evaluate the value of assets, projects, and even entire businesses.

4. Can Account for Changing Circumstances: The DCF method can be adjusted to account for changing circumstances and new information that may become available in the future. This means that investors can revise their valuation estimates as new data becomes available, allowing them to make more informed decisions about their investments.

5. Considers Unique Company Factors: The DCF method takes into account the unique characteristics of a company, such as its growth prospects, market position, and competitive advantages. This means that the valuation produced by the DCF method is tailored to the specific company being evaluated. Overall, the DCF method is a popular and reliable way to evaluate the intrinsic value of a company’s stock. Its focus on future cash flows, incorporation of the time value of money, flexibility, ability to account for changing circumstances, and consideration of unique company factors make it a preferred method for many investors and analysts.

Disadvantages

While the Discounted Cash Flow (DCF) valuation method has several advantages, it is important to note that there are also some disadvantages and limitations to using this technique:

1. Requires Accurate Projections: The DCF method is based on future cash flow projections, which can be challenging to make accurately. Inaccurate projections can lead to incorrect valuations, which can ultimately impact investment decisions.

2. Sensitivity to Discount Rate: The DCF method relies heavily on the discount rate used to calculate the present value of future cash flows. Small changes in the discount rate can significantly affect the valuation estimate.

3. Ignores Market Sentiment: The DCF method focuses solely on fundamental factors and cash flows, ignoring market sentiment and investor behavior. Market sentiment can significantly impact a stock’s price, even if the fundamentals suggest a different value.

4. Time-Consuming: The DCF method can be time-consuming to implement, as it requires extensive analysis and calculation of future cash flows, discount rates, and other inputs.

5. Difficulty in Accounting for External Factors: External factors, such as changes in interest rates, political instability, and changes in industry trends, can significantly impact a company’s future cash flows. Accounting for these factors in the DCF method can be challenging, making the valuation estimate less accurate.

6. Not Suitable for All Companies: The DCF method is most suitable for companies with stable and predictable cash flows. It may not be appropriate for companies that experience significant fluctuations in cash flows or operate in rapidly changing industries.

While the DCF method is a widely used and reliable valuation technique, it is important to understand its limitations and potential drawbacks. It is not a one-size-fits-all approach and should be used in combination with other valuation methods and analysis to make informed investment decisions.

The DCF method guide

The Discounted Cash Flow (DCF) valuation method is a powerful tool that can help investors evaluate the intrinsic value of a stock or a company. Intrinsic value of a stock means assessing what a stock is really worth. When you see those different stock prices on the market, not all of them are fair or actual market values. You see, a stock price can either be undervalued or overvalued, meaning underpriced or overpriced.

In the words of the legendary value investor Warren Buffet, “Intrinsic value of a company is the number that if you were able to predict and were all-knowing about the future and all the cash that a business would give between now and judgment day, discounted to the present day, that is the intrinsic value.”

The DCF method involves estimating the future cash flows that a company will generate and then discounting it back to its present value to arrive at a fair value for the stock.

Before we start with the valuation of a stock, the first precondition is to select a company where cash flows can be easily predicted and the cash flow is generally stable.

While it would be helpful to use an example of a real company from the PSX, we have avoided doing so so that the readers don’t use this article as a recommendation to invest their money. All investors should do their own research before investing in the stock market.

Here is a step-by-step guide on how to carry out the DCF valuation method:

Step 1: Estimate Future Cash Flows

The first step in conducting the DCF valuation method is to estimate the future cash flows that a company is expected to generate. This involves looking at the company’s historical financial statements, analyst reports, and industry trends to forecast the company’s future revenue, expenses, and capital expenditures.

Put simply, look at the free cash flows (FCF) of the company for the past five years, average their growth rate, change the growth rate after considering the industry and analyst reports, and then use that growth rate to project the FCF for the next 5-10 years of the company.

So now you have the projected future cash flows for the next 5-10 years. This projected period could be several years or even decades, depending on the nature of the investment.

One common approach is to use a fiveyear projection period and then estimate the terminal value (we’ll get to this later) of the company beyond the five-year period. It’s essential to be as realistic and accurate as possible when estimating future cash flows, as this will have a significant impact on the final valuation.

Step 2: Determine the Discount Rate

Once the future cash flows of a business have been estimated, the next step is to determine the appropriate discount rate.

The discount rate is important because it is used for Step 3, which is calculating the present value of the future cash flows. Since the value of money falls over time because of inflation, meaning the same amount is worth less in the future than what it is worth today, the future cash flows need to be discounted to the present time.

Discounting the cash flows back to their present value is done using an appropriate discount rate. The discount rate should reflect the time value of money, the risk associated with the investment, and the opportunity cost of capital.

A simple way to get the discount rate is to look at the interest rate in the future. A higher interest rate would mean that the value of the same cash today will be less in the future. But analysts usually use something called the Weighted Average Cost of Capital (WACC) for the discount rate, which is a technical term which we won’t go into right now.

Step 3: Calculate the Present Value of Cash Flows

Once the future cash flows (Step 1) and discount rate (Step 2) have been determined, the next step is to calculate the present value of each future cash flow for each projected year in the future.

The present value of the future cash flow uses the following formula:

PV = CF / (1+r)^n

Where:

PV = Present Value of Cash Flow

CF = Expected Cash Flow r = Discount Rate n = Number of Periods

Note that each projected year’s cash flow will have to be separately discounted one by one.

For example, if a company is expected to generate cash flows of Rs 10 million in year 1, and the discount rate is 10%, the present value of the cash flow in year 1 would be Rs 9.09 million (10 million divided by 1.10 raised to the power of 1).

If in year 2, the company is projected to produce a cash flow of Rs 12 million, then using the same discount rate of 10%, the present value of the cash flow in year 2 would be Rs 9.92 million (12 million divided by 1.10 raised to the power of 2).

This process is repeated for each year’s cash flow, until we have the present value of all future cash flows for all the years we are projecting (5, 10, 15, etc).

Step 4: Calculate the terminal value

However, remember at the start when we used Warren Buffet’s definition of intrinsic value as the value of ALL the cash that the business will generate until judgment day? That means that we also have to project a future cash flow for the years beyond the 5-10 years that we have already projected for and then find a present value for that as well.

This future cash flow of the company is called the Terminal Value. It is the value of all the cash that the business will generate as long as it exists.

Let’s say we projected the cash flows of our company up until year 5 or 5 years into the future. To calculate the terminal value, we will use the year 5 projected cash flow and use a more modest cash flow growth rate than the average historical growth rate we used for the first 5 years. And since this is the growth rate in perpetuity/forever, let’s use the growth rate of the economy which we will assume to be 3%.

The resulting value will be divided by the difference between our discount rate (which we used to get at the present values in step 3) and the perpetual growth rate of 3%. The answer will be the projected terminal value of the company’s cash flow.

The formula is as such:

Terminal Value = (Cash flow year 5 * ( 1 + 3%) ) / (Discount rate - 3%)

But one last thing needs to be done here. This terminal value needs to be discounted to the present as well. The formula will be the same as the one used in step 3 and ‘n’ will be 5 since we are calculating the terminal value from year 5.

When you do this correctly, the present value of the terminal value will probably be 100-500 times more than the year 5 projected cash flow’s present value. This is because the terminal value is the sum of all future cash flows beyond year 5 of our hypothetical company.

Now that we have all the present values up until year 5 and even the present value of the terminal value of the company, all we have to do is sum of all these present values. This will give us the present value of all future cash flows of the company.

Step 5: Compare estimated intrinsic value to market price

If you were able to follow everything up until now, first congratulations are in order. But there is one last final step missing.

The last value we got was the sum of all future cash flows of the company. This total sum needs to be divided by the total outstanding shares of the company to get at the intrinsic value of the company’s stock. When you do this calculation, you will find a number that is the actual intrinsic price of the stock.

But just to be careful, it is best to keep a margin of safety with this intrinsic value and reduce it by 30-60%, depending on how much margin you want to give yourself. This is done because the intrinsic value is just a projected calculation which is not necessarily right. It’s better to reduce the intrinsic value for a decent margin of safety and then use the resulting value for comparison.

The final step in the DCF valuation process is to compare this estimated intrinsic value to the company’s current market price. If the estimated intrinsic value is higher than the market price, the stock may be undervalued and could represent a good investment opportunity. If the estimated intrinsic value is lower than the market price, the stock may be overvalued and investors may want to consider selling or avoiding the stock.

That’s it. You have just learned a highly technical method of stock valuation. Let’s summarize what we learned today.

1. Step 1: Estimate the future cash flows of the company for how long you want to project using the historical growth rates of the free cash flow. Use the final future year’s cash flow to get the terminal value of cash flow.

2. Find an appropriate discount rate and discount all the projected cash flows to the present value.

3. Sum all the present values of the future cash flows.

4. Divide the sum of the present values by the outstanding shares of the company and you will have the intrinsic value of the stock.

5. Compare the intrinsic value of the stock to its current market price and decide whether the stock is a good investment opportunity or not.

In conclusion, the DCF valuation method is a reliable and effective way to estimate the intrinsic value of a company’s stock. By following these steps, investors can gain a better understanding of a company’s financial health and make informed decisions about whether to invest in its stock. However, it’s important to keep in mind that the DCF valuation method is not without its limitations, and investors should consider using other valuation methods as well to arrive at a well-rounded investment decision. n