Understanding the DCF Discounted Cash Flow Method for Stock Valuation

Discounted Cash Flow (DCF) is a widely used financial analytical tool for evaluating the intrinsic value of an investment based on its expected future cash flows. This method is particularly useful for stock valuation, as it provides a framework for determining whether a stock is undervalued, overvalued, or fairly valued. Here, we will walk through a step-by-step guide on how to use DCF for stock valuation.

Step 1: Forecast Future Cash Flows

Estimate Future Cash Flows

The first step in the DCF method is to forecast the future cash flows the company is expected to generate. This typically involves projecting the companyrsquo;s Free Cash Flows (FCFs) over a specific period, usually 5 to 10 years. Cash flows are the primary driver of stock value, and accurate estimates are crucial for a reliable valuation.

Free Cash Flow (FCF) Calculation: FCF can be calculated using the following formula:

FCF Operating Cash Flow - Capital Expenditures

Step 2: Determine the Terminal Value

Calculate Terminal Value

Since companies are expected to generate cash flows indefinitely beyond the projection period, the terminal value must be calculated. The terminal value provides a valuation for all future cash flows after the projection period. It can be calculated using two common methods: the Gordon Growth Model or the Exit Multiple Method.

Terminal Value (FCF in final year * (1 g)) / (r - g)

where g is the perpetual growth rate and r is the discount rate.

Multiply the final yearrsquo;s EBITDA or another relevant metric by an industry multiple.

Step 3: Choose a Discount Rate

Select a Discount Rate

The discount rate is a critical input in the DCF model, typically represented by the companyrsquo;s Weighted Average Cost of Capital (WACC). WACC reflects the overall cost of capital and accounts for both the cost of equity and the cost of debt, weighted by their respective proportions in the capital structure. The formula for calculating WACC is:

WACC (E/V) * Re (D/V) * Rd * (1 - Tc)

where E is the market value of the companyrsquo;s equity, D is the market value of the companyrsquo;s debt, V E D, Re is the cost of equity, Rd is the cost of debt, and Tc is the tax rate.

Step 4: Discount Future Cash Flows and Terminal Value

Discount Cash Flows

To discount future cash flows and the terminal value back to their present values, use the discount rate using the following formula:

PV FCF / (1 r)^t

where t is the year number.

Step 5: Sum the Present Values

Calculate the Total Present Value

Add the present values of all projected cash flows and the terminal value to get the total present value.

Total PV Sum(PV of FCFs) PV of Terminal Value

Step 6: Determine the Intrinsic Value per Share

Calculate Intrinsic Value

To find the intrinsic value per share, divide the total present value by the number of outstanding shares.

Intrinsic Value per Share Total PV / Number of Shares Outstanding

Step 7: Compare with Market Price

Make Investment Decision

Compare the intrinsic value per share with the current market price of the stock. If the intrinsic value is higher than the market price, the stock may be undervalued and a good candidate for investment. Conversely, if the intrinsic value is lower, the stock is likely overvalued.

Example

Consider a hypothetical company expected to generate the following FCFs over the next five years: $100 million, $120 million, $140 million, $160 million, and $180 million. Assuming a terminal growth rate of 3% and a WACC of 10%, we can calculate the terminal value as follows:

Terminal Value (180 * (1 0.03)) / (0.10 - 0.03) 2648.57 million

Discount the cash flows and terminal value back to their present values. Sum the present values and divide by the number of shares outstanding. The intrinsic value per share can then be determined.

Conclusion: DCF is a powerful tool for stock valuation as it provides a solid basis for investment decisions. However, it is important to recognize that the DCF method is highly sensitive to input assumptions, and sensitivity analysis should be conducted to assess the impact of changing these assumptions on the intrinsic value.