By Ben McClure
It can be hard to understand how stock analysts come up with "fair value" for companies, or why their target price estimates vary so wildly. The answer often lies in how they use the valuation method known as discounted cash flow (DCF). However, you don't have to rely on the word of analysts. With some preparation and the right tools, you can value a company's stock yourself using this method. This tutorial will show you how, taking you step-by-step through a discounted cash flow analysis of a fictional company.
In simple terms, discounted cash flow tries to work out the value of a company today, based on projections of how much money it's going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as"discounted" cash flow because cash in the future is worth less than cash today. (To learn more, see The Essentials Of Cash Flow and Taking Stock Of Discounted Cash Flow.)
For example, let's say someone asked you to choose between receiving $100 today and receiving $100 in a year. Chances are you would take the money today, knowing that you could invest that $100 now and have more than $100 in a year's time. If you turn that thinking on its head, you are saying that the amount that you'd have in one year is worth $100 dollars today - or the discounted value is $100. Make the same calculation for all the cash you expect a company to produce in the future and you have a good measure of the company's value.
There are several tried and true approaches to discounted cash flow analysis, including the dividend discount model (DDM) approach and the cash flow to firm approach. In this tutorial, we will use the free cash flow to equity approach commonly used by Wall Street analysts to determine the "fair value" of companies.
As an investor, you have a lot to gain from mastering DCF analysis. For starters, it can serve as a reality check to the fair value prices found in brokers' reports. DCF analysis requires you to think through the factors that affect a company, such as future sales growth and profit margins. It also makes you consider the discount rate, which depends on a risk-free interest rate, the company's costs of capital and the risk its stock faces. All of this will give you an appreciation for what drives share value, and that means you can put a more realistic price tag on the company's stock.
To demonstrate how this valuation method works, this tutorial will take you step-by-step through a DCF analysis of a fictional company called The Widget Company. Let's begin by looking at how to determine the forecast period for your analysis and how to forecast revenue growth.
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