Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital, which we'll discuss in section 13 of this walkthrough) to arrive at a present value, which is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
The formula for calculating DCF is usually given something like this:
PV = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k - g)] / (1+k)n-1
PV = present value
CFi = cash flow in year i
k = discount rate
TCF = the terminal year cash flow
g = growth rate assumption in perpetuity beyond terminal year
n = the number of periods in the valuation model including the terminal year
There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. For example, free cash flows can be calculated as operating profit + depreciation + amortization of goodwill - capital expenditures - cash taxes - change in working capital. Although the calculations are complex, the purpose of DCF analysis is simply to estimate the money you'd receive from an investment and to adjust for the time value of money.
Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out." Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.
At a time when financial statements are under close scrutiny, the choice of what metric to use for making company valuations has become increasingly important. Wall Street analysts are emphasizing cash flow-based analysis for making judgments about company performance.
DCF analysis is a key valuation tool at analysts' disposal. Analysts use DCF to determine a company's current value according to its estimated future cash flows. For investors keen on gaining insights on what drives share value, few tools can rival DCF analysis.
Accounting scandals and inappropriate calculation of revenues and capital expenses give DCF new importance. With heightened concerns over the quality of earnings and reliability of standard valuation metrics like P/E ratios, more investors are turning to free cash flow, which offers a more transparent metric for gauging performance than earnings. It is harder to fool the cash register. Developing a DCF model demands a lot more work than simply dividing the share price by earnings or sales. But in return for the effort, investors get a good picture of the key drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet capital structure, cost of equity and debt, and expected duration of growth. An added bonus is that DCF is less likely to be manipulated by aggressive accounting practices.
DCF analysis shows that changes in long-term growth rates have the greatest impact on share valuation. Interest rate changes also make a big difference. Consider the numbers generated by a DCF model offered by Bloomberg Financial Markets. Sun Microsystems, which in 2012 traded on the market at $3.25, is valued at almost $5.50, which makes its price of $3.25 a steal. The model assumes a long-term growth rate of 13%. If we cut the growth rate assumption by 25%, Sun's share valuation falls to $3.20. If we raise the growth rate variable by 25%, the shares go up to $7.50. Similarly, raising interest rates by one percentage point pushes the share value to $3.55; a 1% fall in interest rates boosts the value to about $7.70.
Investors can also use the DCF model as a reality check. Instead of trying to come up with a target share price, they can plug in the current share price and, working backwards, calculate how fast the company would need to grow to justify the valuation. The lower the implied growth rate, the better - less growth has therefore already been "priced into" the stock.
Best of all, unlike comparative metrics like P/Es and price-to-sales ratios, DCF produces a bona fide stock value. Because it does not weigh all the inputs included in a DCF model, ratio-based valuation acts more like a beauty contest: stocks are compared to each other rather than judged on intrinsic value. If the companies used as comparisons are all over-priced, the investor can end up holding a stock with a share price ready for a fall. A well-designed DCF model should, by contrast, keep investors out of stocks that look cheap only against expensive peers.
DCF models are powerful, but they do have shortcomings. Small changes in inputs can result in large changes in the value of a company. Investors must constantly second-guess valuations; the inputs that produce these valuations are always changing and are susceptible to error.
Meaningful valuations depend on the user's ability to make solid cash flow projections. While forecasting cash flows more than a few years into the future is difficult, crafting results into eternity (which is a necessary input) is near impossible. A single, unexpected event can immediately make a DCF model obsolete. By guessing at what a decade of cash flow is worth today, most analysts limit their outlook to 10 years. Investors should watch out for DCF models that project to ridiculous lengths of time. Also, the DCF model focuses on long-range investing; it isn't suited for short-term investments.
Investors shouldn't base a decision to buy a stock solely on discounted cash flow analysis - it is a moving target, full of challenges. If the company fails to meet financial performance expectations, if one of its big customers jumps to a competitor, or if interest rates take an unexpected turn, the model's numbers have to be re-run. Any time expectations change, the DCF-generated value is going to change.
While many finance courses espouse the gospel of DCF analysis as the preferred valuation methodology for all cash flow generating assets, in practice, DCF can be difficult to apply in the valuation of stocks. Even if one believes the gospel of DCF, other valuation approaches are useful to help generate a complete valuation picture of a stock.
Even if one believes that DCF is the final word in assessing the value of an equity investment, it is very useful to supplement the approach with multiple-based target price approaches. If you are going to project income and cash flows, it is easy to use the supplementary approaches. It is important to assess which trading multiples (P/E, price/cash flow, etc.) are applicable based on the company's history and its sector. Choosing a target multiple range is where it gets tricky.
While this is analogous to arbitrary discount rate selection, by using a trailing earnings number two years out and an appropriate P/E multiple to calculate a target price, this will entail far fewer assumptions to "value" the stock than under the DCF scenario. This improves the reliability of the conclusion relative to the DCF approach. Because we know what a company's P/E or price/cash flow multiple is after every trade, we have a lot of historical data from which to assess the future multiple possibilities. In contrast, the DCF model discount rate is always theoretical, and we do not really have any historical data to draw from when calculating it.
For more insight, read Discounted Cash Flow Analysis, Top 3 Pitfalls Of Discounted Cash Flow Analysis and our DCF Analysis Tutorial.
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