1. Stock-Picking Strategies: Introduction
  2. Stock-Picking Strategies: Fundamental Analysis
  3. Fundamental Analysis: Figuring Discounted Cash Flow
  4. Stock-Picking Strategies: Qualitative Analysis
  5. Stock-Picking Strategies: Value Investing
  6. Stock-Picking Strategies: Growth Investing
  7. Stock-Picking Strategies: GARP Investing
  8. Stock-Picking Strategies: Income Investing
  9. Stock-Picking Strategies: CAN SLIM
  10. Stock-Picking Strategies: Dogs of the Dow
  11. Stock-Picking Strategies: Technical Analysis
  12. Stock-Picking Strategies: Conclusion

The idea of discounting cash flows seems okay in theory, but implementing it in real life is difficult. One of the most obvious challenges is determining how far into the future we should forecast cash flows. It's hard enough to predict next year's profits, so how can we predict the course of the next 10 years? What if a company goes out of business? What if a company survives for hundreds of years? 

All of these uncertainties and possibilities explain why there are many different models devised for discounting cash flows, but none completely escapes the complications posed by the uncertainty of the future.

Putting the Discounted Cash Flow Theory into Practice

Let's look at a sample of a model used to value a company. Because this is a generalized example, don't worry if some details aren't clear. The purpose is to demonstrate the bridging between theory and application. Take a look at how valuation based on fundamentals would look:

The problem with projecting far into the future is that we have to account for the different rates at which a company will grow as it enters different phases. To get around this problem, this model has two parts: (1) determining the sum of the discounted future cash flows from each of the next five years (years one to five), and (2) determining 'residual value,' which is the sum of the future cash flows from the years starting six years from now.

In this particular example, the company is assumed to grow at 15% a year for the first five years and then 5% every year after that (year six and beyond). First, we add together all the first five yearly cash flows – each of which is discounted to year zero, the present – in order to determine the present value (PV).

Once the present value of the company for the first five years is calculated, we must, in the second stage of the model, determine the value of the cash flows coming from the sixth year and all the following years, when the company's growth rate is assumed to be 5%. The cash flows from all these years are discounted back to year five and added together, then discounted to year zero, and finally combined with the PV of the cash flows from years one to five (which we calculated in the first part of the model). And voilà! We have an estimate (given our assumptions) of the intrinsic value of the company.

Understanding the Details

An estimate that is higher than the current market capitalization indicates that it may be a good buy. Below, we have gone through each component of the model with specific notes:

  1. Prior-year cash flow – The theoretical amount, or total profits, that the shareholders could take from the company the previous year.
  2. Growth rate – The rate at which owner's earnings are expected to grow for the next five years.
  3. Cash flow – The theoretical amount that shareholders would get if all the company's earnings, or profits, were distributed to them.
  4. Discount factor – The number that brings the future cash flows back to year zero. In other words, the factor used to determine the cash flows' present value (PV).
  5. Discount per year – The cash flow multiplied by the discount factor.
  6. Cash flow in year five – The amount the company could distribute to shareholders in year five.
  7. Growth rate – The growth rate from year six into perpetuity.
  8. Cash flow in year six – The amount available in year six to distribute to shareholders.
  9. Capitalization Rate – The discount rate (the denominator) in the formula for a constantly growing perpetuity.
  10. Value at the end of year five – The value of the company in five years.
  11. Discount factor at the end of year five – The discount factor that converts the value of the firm in year five into the present value.
  12. PV of residual value – The present value of the firm in year five.

So far, we've been very general on what a cash flow comprises, and unfortunately, there is no easy way to measure it. The only natural cash flow from a public company to its shareholders is a dividend, and the dividend discount model (DDM) values a company based on its future dividends (see Digging into the DDM.). However, a company doesn't pay out all of its profits in dividends, and many profitable companies don't pay dividends at all.

What happens in these situations? Other valuation options include analyzing net income, free cash flow, EBITDA and a series of other financial measures. There are advantages and disadvantages to using any of these metrics to get a glimpse into a company's intrinsic value. The point is that what represents cash flow depends on the situation. Regardless of which model is used, the theory behind all of them is the same.


Stock-Picking Strategies: Qualitative Analysis
Related Articles
  1. Investing

    Evaluating A Statement Of Cash Flows

    The metrics for the Statement of Cash Flows is best viewed over time.
  2. Investing

    The Essentials Of Corporate Cash Flow

    Tune out the accounting noise and see whether a company is generating the stuff it needs to sustain itself.
  3. Tech

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  4. Investing

    Free Cash Flow Yield: The Best Fundamental Indicator

    Cash in the bank is what every company strives to achieve. Find out how to determine how much a company is generating and keeping.
  5. Investing

    Value Investing: Why Investors Care About Free Cash Flow Over EBITDA

    Examine value investing philosophy and methodology to see why free cash flow is more important than EBITDA in pure intrinsic value calculation.
  6. Investing

    Operating Cash Flow: Better Than Net Income?

    Differences between accrual accounting and cash flows show why net income is easier to manipulate.
  7. Investing

    Key Fundamental Investment Metrics

    Fundamental investors believe certain factors dictate a stock’s performance. There are a few key indicators that fundamental investors should know.
  8. Investing

    Free Cash Flow Yield: A Fundamental Indicator

    Free cash flow can measure a business’s performance as if you’re looking at its net income line.
Frequently Asked Questions
  1. Do interest rates increase during a recession?

    Learn why interest rates do not rise in a recession; in fact, the opposite happens. Identify the factors that reduce interest ...
  2. What is the difference between deflation and disinflation?

    Learn what deflation and disinflation are, how supply and demand affect price levels, and the difference between deflation ...
  3. What rights do all common shareholders have?

    Learn what rights all common shareholders have, and understand the remedies that can be taken if those rights are violated ...
  4. What does CHIPS UID mean?

    Learn what CHIPS UID stands for and how it facilitates the transfer of funds as the back-end of the ACH network for both ...
Trading Center