For most people, discounted cash flow (DCF) valuation seems like a financial art form, best left to Ph.D.s and Wall Street technical wizards. DCF intricacies do involve complex math and financial modeling. Still, if you understand the basic concepts behind DCF, you can perform "back-of-the-envelope" calculations to help you make investment decisions or value small businesses. This article will discuss a few practical applications.

Key Takeaways

  • Discounted cash flow (DCF) is a method of valuation used to determine the value of an investment based on its return or future cash flows.
  • The weighted average cost of capital is used as a hurdle rate, meaning the investment's return must outperform the hurdle rate.
  • Although DCF is the standard for valuing privately-held companies; it can also be used as an acid test for publicly-traded stocks.

Understanding Discounted Cash Flow (DCF)

Discounted cash flow (DCF) is a method of valuation used to determine the value of an investment based on its return in the future–called future cash flows. DCF helps to calculate how much an investment is worth today based on the return in the future. DCF analysis can be applied to investments as well as purchases of assets by company owners.

DCF is a valuation method that can be used for privately-held companies. It projects a series of future cash flows, EBITDA or earnings and then discounts for the time value of money. The time value of money is a concept that states that one dollar today is worth more than one dollar in the future because the one dollar from today can be invested. 

Discounted cash flow uses a discount rate to determine whether the future cash flows of an investment are worth investing in or whether a project is worth pursuing. The discount rate is the risk-free rate of return or the return that could be earned instead of pursuing the investment. For example, a discount rate might be the rate for a 2-year U.S. Treasury bill. If the project or investment can't generate enough cash flows to beat the Treasury rate (or risk-free rate), it's not worth pursuing. In other words, the risk-free rate is subtracted (or discounted) from the expected returns of an investment to arrive at the true investment gain, so that investors can determine whether it's worth the risk.

DCF Usages

Also, a company's own weighted average cost of capital (WACC) over a period of five to 10 years can be used as the discount rate in DCF analysis.

WACC calculates the cost of how a company raises capital or funds, which can be from bonds, long-term debt, common stock, and preferred stock. WACC is often used as the hurdle rate that a company needs to earn from an investment or project. Returns below the hurdle rate (or the cost of obtaining capital) aren't worth pursuing.

The expected future cash flows from an investment are discounted or reduced by the WACC to factor in the cost of achieving capital. The sum of all future discounted flows is the company's present value. Professional business appraisers often include a terminal value at the end of the projected earnings period. While the typical forecast period is roughly five years, terminal value helps determine the return beyond the forecast period, which can be difficult to forecast that far out for many companies. Terminal value is the stable growth rate that a company or investment should achieve in the long-term (or beyond the forecast period).

Some analysts might also apply discounts in DCF analysis for small-company risk, lack of liquidity, or shares representing a minority interest in the company.

An Acid Test for Valuing a Public Stock

DCF is a blue-ribbon standard for valuing privately-held companies; it can also be used as an acid test for publicly-traded stocks. Public companies in the United States may have P/E ratios (determined by the market) that are higher than DCF. The P/E ratio is the stock price divided by a company's earnings per share (EPS), which is net income divided the total of outstanding common stock shares.

This is especially true of smaller, younger companies with high costs of capital, and uneven or uncertain earnings or cash flow. But it also can be true of large, successful companies with astronomical P/E ratios.

For example, let's do a simple DCF test to check whether Apple stock was fairly valued at a given point in time. During June of 2008, Apple had a market capitalization of $150 billion. The company was generating operating cash flow of around $7 billion per year, and we'll assign a WACC of 7% to the company because it is financially strong and can raise equity and debt capital inexpensively. We'll also assume that Apple can increase its operating cash flow by 15% per year over the 10-year period, a somewhat aggressive assumption because few companies are capable of sustaining such high growth rates over lengthy periods.

On this basis, DCF would value Apple at a market capitalization of $106.3 billion, 30% below its stock market price at the time. In this case, DCF provides one indication that the market may be paying too high of a price for Apple common stock. Smart investors might look to other indicators, such as the inability to sustain cash flow growth rates in the future, for confirmation.

The Importance of WACC on Stock Market Valuations

Doing just a few DCF calculations demonstrates the link between a company's cost of capital and its valuation. For large public companies (such as Apple), the cost of capital tends to be somewhat stable. But for small companies, this cost can fluctuate significantly over economic and interest rate cycles. The higher a company's cost of capital, the lower its DCF valuation will be. For the smallest companies (below about $500 million in market cap), DCF technicians may add a "size premium" of 2-4% to the company's WACC to account for the additional risk.

During the credit crunch of 2007 and 2008, the cost of capital for the smallest public companies soared as banks tightened lending standards. Some small public companies that could tap bank credit at 8% in 2006 suddenly had to pay 12-15% to hedge funds for increasingly-scarce capital. Using simple DCF valuation, let's see what the impact of increasing WACC from 8% to 14% would be on a small public company with $10 million in annual cash flow and projected annual cash flow growth of 12% over a 10-year period.

Net present value of the company @ 8% WACC $143.6 million
Net present value of the company @ 14% WACC $105.0 million
Decline in net present value $ $38.6 million
Decline in net present value % 26.9%

Based on the higher cost of capital, the company is valued at $38.6 million less, representing a 26.9% decline in value.

Building a Company's Value

If you are building a small company and hope to sell it one day, DCF valuation can help you focus on what is most important–generating steady growth on the bottom line. In many small companies, it's difficult to project cash flow or earnings years into the future, and this is especially true of companies with fluctuating earnings or exposure to economic cycles. A business valuation expert is more willing to project growing cash flows or earnings over a lengthy period when the company has already demonstrated this ability.

Another lesson taught by DCF analysis is to keep your balance sheet as clean as possible by avoiding excessive loans or other forms of leverage. Awarding stock options or deferred compensation plans to a company's top executives can strengthen a company's appeal to attract quality management. However, it can also create future liabilities that will increase the company's cost of capital.

The Bottom Line

DCF valuation isn't just financial rocket science. It also has practical applications that can make you a better stock market investor because it serves as an acid test of what a public company would be worth if it were valued the same as comparable private companies. Astute, value-minded investors use DCF as one indicator of value, and also as a "safety check" to avoid paying too much for shares of stock, or even a whole company.