How to Use the Discounted Cash Flow Model to Value Stock
When evaluating a company's value, cash flow is king
You must do your homework before investing in a company. Many models exist to evaluate a company's financial performance and calculate estimated returns to reach an objective share price. One great way to do it is by measuring the company's cash flow, or how much money a company has at the end of the year compared to the beginning.
The discounted cash flow model (DCF) is one common way to value an entire company and, by extension, its shares of stock. It is considered an “absolute value” model, meaning it uses objective financial data to evaluate a company, instead of comparisons to other firms. The dividend discount model (DDM) is another absolute value model that is widely accepted, though it may not be appropriate for certain companies.
The DCF Model Formula
The DCF formula is more complex than other models, including the dividend discount model:
Present value = [CF1 / (1+k)] + [CF2 / (1+k)2] + ... [TCF / (k-g)] / (1+k)n-1]
That’s fairly complicated, but let’s define the terms:
- CF1: The expected cash flow in year one
- CF2: The expected cash flow in year two
- TCF: The “terminal cash flow,” or expected cash flow overall. This is usually an estimate, as calculating anything beyond 5 years or so is guesswork.
- k: The discount rate, also known as the required rate of return
- g: The expected growth rate
- n: The number of years included in the model
There is a simpler way of examining this, however.
Let’s examine a small fictional company, Dinosaurs Unlimited. Say we’re calculating for 5 years out, the discount rate is 10% and the growth rate is 5%. (Note: There are two different ways of calculating terminal cash flow. For simplicity, let’s assume the terminal value is three times the value of the fifth year.)
If we assume that Dinosaurs Unlimited has a cash flow of $1 million now, its discounted cash flow after a year is $909,000. (We are assuming a discount rate of 10%.)
In subsequent years, cash flow is increasing by 5%. Thus, new discounted cash flow figures over a 5-year period are:
Year 2: $867,700
Year 3: $828,300
Year 4: $792,800
Year 5: $754,900
We noted above that the terminal value will be three times that of the value in the fifth year. So that comes to $2.265 million. Add all these figures, and you come to $6.41 million. Based on this analysis, that's the value of Dinosaurs Unlimited. But what if Dinosaurs Unlimited were a publicly-traded company? We could determine whether its share price was fair, too expensive, or a potential bargain.
Let’s assume that Dinosaurs Unlimited is trading at $10 per share, and there are 500,000 shares outstanding. That represents a market capitalization of $5 million. Thus, a $10 share price is on the low side. If you are an investor, you might be willing to pay nearly $13 per share, based on the value stemming from the DCF.
Advantages and Limitations of the DCF Model
Accounting scandals in recent years have placed new importance on cash flow as a metric for determining proper valuations. Cash flow is generally harder to manipulate in earnings reports than profits and revenue.
Cash flow, however, can be misleading in some instances. If a company sells a lot of its assets, for example, it may have positive cash flow but may actually be worthless without those assets. It’s also important to note whether a company is sitting on piles of cash or reinvesting back into the company.
Like other models, the discounted cash flow model is only as good as the information entered, and that can be a problem if accurate cash flow figures aren’t available. It’s also more difficult to calculate than some metrics, such as those that simply divide the share price by earnings. But if you are willing to do the work, it can be a good way of determining whether it's a good idea to invest in this company.