One of your most important jobs as an investor is to figure out whether a stock is overvalued or undervalued so that you can profit. One of the most popular methods for assessing a company’s value is a discounted cash flow (DCF) analysis. Here’s a look at how discounted cash flow analysis works and how it can help boost your portfolio gains.
The Short Version
What Is Cash Flow Analysis and Why Does It Matter?
Discounted cash flow analysis lets you value a company or investment based on its projected future cash flows. DCF analysis matters because it can help you decide if a stock, or financial asset, is a good investment.
You can use the DCF model to determine the intrinsic value of an investment. That’s investor lingo for the true underlying value of the company. With the inherent worth and current market value in hand, you can easily decide if you think an investment is overvalued or undervalued. When you pick undervalued stocks, you set yourself up for future investment gains.
Private equity firms, Wall Street investment banks, and hedge fund managers rely on DCF models in their analysis and business decisions. If the wealthiest people and companies in the world use this method, then it's probably for a very good reason.
How Do You Conduct Discounted Cash Flow Analysis?
The DCF model is based on a well-known formula in the investment and finance world:
DCF = [(CF) ÷ (1 + r)^1] + [(CF) ÷ (1 + r)^2] + [(CF) + (1 + r)^n]
CF stands for cash flow for a specific future year in this formula. n stands for the number of years when calculating multiple years at once. r is the discount rate.
Before you use the DCF formula to conduct the analysis, you'll need to go through a few steps to estimate the company’s future cash flows. Every investor uses their own methods and assumptions to estimate future cash flows. Don’t underestimate the importance of these assumptions and projections — they play a critical role in the calculation.
The discount rate, r, is a measure of the company’s risk and can decide whether an investment is expected to be profitable or not. The discount rate tells you the present value of the expected future cash flows.
Where Can the Discounted Cash Flow Method Be Used?
The discounted cash flow model helps you value a wide range of investments, including stocks, bonds, funds, and private investments – plus anything else that requires an upfront investment for expected future repayments.
The DCF model is a handy tool for picking stocks for the typical individual investor’s portfolio. It’s a type of fundamental analysis that helps you determine a company's intrinsic value or what you believe the business is worth today. If you, like Warren Buffett, are a fan of value investing, you likely rely heavily on DCF and similar valuation models.
Business owners and managers can use the DCF model to analyze specific investments. For example, let’s say a local limousine company is debating whether or not to buy a new stretch limo. Using a DCF analysis, the business can estimate future income and costs related to the limo to determine future cash flows. The DCF model can help the company understand if the capital expenditure will offer a suitable payoff.
When deciding between two different investments, you can use the discounted cash flow method to determine which one is better. If you have a limited amount of money or working capital to invest, doing several DCF analyses can help you build the optimal, diversified investment portfolio.
What Is the Discount Rate, and Why Is It Important?
The discount rate (not to be confused with the Federal Reserve discount rate) measures a company’s risk and expected return. Very safe investments in stable companies earn a low discount rate. Investments in a risky company or startup, meanwhile, would require a higher discount rate.
If you have no idea what to pick for a discount rate, look at the company’s current interest rate for bonds on secondary markets. The effective interest rate for fixed-income investments is roughly equated to the market’s risk tolerance and required rate of return for the company.
For example, Twitter sold $700 million in bonds in 2019. Those bonds were trading at a 4.2% interest rate at the time of writing. Considering Twitter’s stock, 4.2% could be a reasonable discount rate. Compare that with the ultra-stable IBM, currently yielding about 3.6% and the slightly-riskier Sirius XM, which yields 5%, to get an idea of discount rates for public companies. Very risky investments can see discount rates of 20% or more.
A high discount rate leads to a lower present value of cash flows. Conversely, a low discount rate leads to a higher present value. This is how you account for the potential that a company won’t meet your projections for future cash flows.
How Do You Use Discounted Cash Flow To Value a Company?
Follow these steps to use DCF to value a company:
- Gather company financial data. Start by gathering the latest financial information for the company. You can find this through a recent SEC filing, such as a 10K or 10Q, or by using a preferred financial data resource, or perhaps through your brokerage.
- Create estimates for future cash flows. Use a spreadsheet to recreate the recent data. Use assumptions on growth trends to build out your future cash flow model.
- Choose a discount rate. Next, pick your preferred discount rate. Again, you can use the company’s current bond rates as a guideline. However, some investors choose to be more or less aggressive when choosing discount rates based on their investment philosophies and opinion of the business.
- Calculate present value. Now comes the heavy math. But, if you are good with spreadsheet apps, it’s relatively easy to do the calculations. They don’t require anything more challenging than what you learned in high school algebra class. Calculus isn’t needed!
- Compare to the current stock price. The DCF model should give you the total company value. Divide by the number of shares outstanding to get your current estimated value per share.
Wise investors don’t use the DCF model alone. You may choose to use the DCF model in conjunction with market valuation ratios. For example, you could use your DCF calculation for 70% of the price and a combination of ratios for the remaining 30%. Again, every investor has their own unique preferences and style here. There’s no right or wrong answer, just what’s right for your portfolio.
The process described above is a lot of work; investors may find it to be too time-consuming. In that case, using an investment research platform such as Stock Rover that provides data and completes the discounted cash analysis for you may help you to make informed decisions.
What Is a Good Value for the Perpetual Growth Rate in the Discounted Cash Flow Model?
Every business is different, so there’s no general guideline to follow regarding perpetual growth rates for the final years of your model. These are represented by the n variable in the formula above.
In general, it’s a good idea to assume that a company’s growth rate will slow over time. That’s because it’s trying to grow to a larger number in the future and because it may get harder to win new business.
As with other parts of your cash flow analysis, you will have to make some assumptions here to determine the fair value of the business.
The Bottom Line
One of the foundational rules of investing is to rely on the numbers instead of your gut. While it’s fun to follow hot stock tips or your gut instincts and to mimic trades from the r/wallstreetbets subreddit, you are better off following the numbers and data in most cases.
For seasoned investors, this may mean using a discounted cash flow analysis to decide if stocks are worth buying and keeping. When you know the numbers, you put yourself in a better position to have many years of successful investments ahead of you.
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