Before investing in a company, you need to look at a few crucial factors. Many models exist to evaluate a company's financial health and calculate estimated returns to reach an objective share price. One great way to do it is by measuring the company's cash flow. This means looking at how much money a company has at the end of the year, compared to the beginning of the year.
What Is the Discounted Cash Flow Model?
The discounted cash flow model (DCF) is one common way to value an entire company. When you use the DCF to value a company, you are able to decide how much its shares of stock should cost.
DCF is considered an “absolute value” model. 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. The formula is:
Present value = [CF1 / (1+k)] + [CF2 / (1+k)2] + ... [TCF / (k-g)] / (1+k)n-1]
That looks fairly tricky, 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 five 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 looking at this, however.
Let’s look at a small fictional company, Dinosaurs Unlimited. Suppose we’re calculating for five 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 would be $909,000. We arrive at that number by assuming a discount rate of 10%.
In the years that follow, cash flow is increasing by 5%. Thus, new discounted cash flow figures over a five-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.
Pros and Cons of the DCF Model
Accounting scandals in recent years have placed a new importance on cash flow as a metric for determining proper valuations.
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 them. It’s also crucial to note whether a company is sitting on piles of cash or reinvesting back into the company.
Cash flow is generally harder to manipulate in earnings reports than are profits and revenue.
Like other models, the discounted cash flow model is only as good as the information entered, and that can be a problem if you don't have access to accurate cash flow figures. It’s also harder to calculate than other metrics, such as those that simply divide the share price by earnings. If you are willing to do the work, this can be a good way to decide whether it's a sound idea to invest in a company.