The discounted cash flow method can be a little tricky to understand, so don’t worry if it is overwhelming at first.
It is a valuation method that is used in fundamental analysis. The calculation is used to estimate the value of a company, based on the expected future cash flows of the business.
The formula is as follows
CF stands for the cash flow for a given year, r stands for the discount rate and n is the additional years that you would add.
It is common to use 5 years worth of cash flows in the model. The cash flows should be forecasted for the next 5 years, which can be done by find the average growth rate of the cash flows of the business in the last 5 years. You can find this information by using the annual report of the stock that you are interested in.
For example, if a company experienced cash flows of $100m, $120m, $80m, $140m and $60m in the last 5 years, we could calculate that this happened at a growth rate of around 1.13% (the average percentage change between pair added together, divided by the number of total pairs). Then, we could multiply this figure by the last year to have a rough idea of what the cash flows could be in the future.
In this case, the next 5 cash flows would be $60.68m, $61.36m, $62.06m, $62.76m and $63.47m. Clearly these numbers are unlikely to be totally accurate but they do account for the current growth rate of the company. In order to estimate the future cash flows more precisely it would take a lot of financial modelling and research.
To calculate the discount rate, the following formula for the weighted-average cost of capital is used (WACC).
Where MVe is the market value of the company’s equity, MVd is the market value of the company’s debt, Re is the cost of equity, Rd is the cost of debt and t is the corporate tax rate.
The market value of the company’s equity can just be the market capitalisation of the stock, while the market value of the company’s debt is the amount of money they have in debt. This information is available in the annual report of each company.
The corporate tax rate is just the corporate tax rate in the country in which they operate or are listed in.
So, you can see that a lot of the information needed is easily available. The more challenging information to acquire is the cost of equity and cost of debt.
The cost of equity is calculated using the formula: Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return).
The risk-free rate of return is usually just the return achieved with a 3-month government bond, the beta for a stock is available via the annual report of the company or Yahoo Finance, while the market rate of return is the return of the main stock market index (usually around 10%).
For example, 0.974% + 0.7 x (10% – 0.974%) = 7.9%.
The cost of debt is calculated by determining the percentage that a company pays as interest on their debt. This information is available in the annual report of each company or via Yahoo finance (which is more easy to understand).
Once you know the total debt of a company and how much they pay in interest, you simply divide the amount they pay in interest by the total debt (i.e. (5m/300m) x 100 = 1.67%).
To illustrate how this would all come together, we will use the examples that we have already calculated.
So, we will assume that the future cash flows will be $60.68m, $61.36m, $62.06m, $62.76m and $63.47m, that the cost of equity of the stock is 7.9% and that the cost of debt is 1.67%.
We will also assume that the market capitalisation of the stock is 900m, that the market value of the debt is $300m and that the corporation tax rate is 10%.
Firstly the discount rate calculation would be: ((900m/300m + 900m) x 7.9%) + (((300m/300m+900m) x 1.67%) x 10%) = 6.3%.
Then, we can calculate the value of the company by using the original discounted cash flow model. Which would be the following.
$60.68m/(1+6.3%)¹ + $61.36m/(1+6.3%)² + $62.06m/(1+6.3%)³ + $62.76m/(1+6.3%)⁴ + $63.47m/(1+6.3%)⁵ = 258m (roughly)
To estimate the future share price of a company, you would then divide the discounted cash flow figure by the number of total shares outstanding.
So, let’s assume that the company has 200,000 shares outstanding. It would be 258m/200,000 = $1,290.
Therefore, if the share price is higher than this number (i.e. $3,000), it suggests that we should not buy the stock. However, if the current share price is lower than this figure (i.e. $300), it suggests that we should buy the stock.
In this example, you may have noticed that the market capitalisation is $300m, which is higher than the 258m figure that we calculated, meaning that the stock should be avoided.
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