What is DCF?
Discounted cash flow is a valuation method that finds the present value of discounted future cash flows using a discount rate. In a broad sense, it relies on the "time value of money" concept, which states that a dollar today is worth more than a dollar tomorrow (because the dollar today can be invested and can earn interest). DCF is used throughout the financial industry and can be used to value almost any cash-generating asset.
Why would you want to use it?
There are more steps that go into the calculation of DCF than for more simple metrics like price-earnings, price-book, dividend yield and so on. So why go to the trouble of doing it? DCF allows you to compare companies from different industries, or in different stages of the growth cycle, whereas comparables like price-earnings always need to be viewed in the context of the group the security is in. DCF allows you to consider two unrelated investments based purely on their ability to generate cash for shareholders.
What kind of assumptions go into it?
So how does one calculate DCF? Since we cannot predict the future, any estimate of cash flow must be just that - an estimate. However, there are a number of questions that we can ask to help guide us in this process. First, what has the company’s cash flow been like recently? Is it growing, shrinking or stable? What effect will revenue growth have on cash flow? Will the business’ costs scale with revenue, or does it benefit from operating leverage? What kind of moat does your company have? Are competitors gaining on it, or falling behind?
As you can see, an awful lot can go into these considerations, and it is the job of the security analyst to sort through what is and isn’t important. Once you have a reasonable estimate of future cash flows, you are ready to move on to the next step in the process - actually building a model.
Building the model
A dollar today is worth more than a dollar tomorrow. But by how much? This is where the discount rate comes in. The discount rate is the amount of interest you could be reasonably expected to earn on your investment today. If you have $100 today and think that you could earn 5% annual interest on it, then in a year you will have $105. A year after that, $110.25.
What we need to figure out is how much money we need to have today so that we will have $100 in a year’s time. To find this, we divide the future cash flow of $100 by the amount it will be worth in a year. For example, $100/$105 = $95.24. If you invested $95.24 today at an annual interest rate of 5%, you would have $100 in a year’s time. Ergo, a cash flow of $100 in a year’s time is equivalent to a cash flow of $95.24.
Stated generally, the formula for calculating DCF is as follows:
Present value of cash flow in year n = cash flow in year n/(1 + r)^n
Where "r" is the discount rate.
Let’s illustrate this with an example.
We have estimated that a business will generate a cash flow of $5,000 in two year’s time. We estimate the annual discount rate to be 3%. The calculation is:
$5000/(1 + 0.03)^2 = $5000/(1.03)^2 = $5000/1.0609 = $4,712.98
The longer you have to wait and the higher the discount rate, the less valuable is the cash flow right now.
In this example, we have assumed the investor is applying a discount rate based on the risk-free return they think they can earn by parking their money elsewhere. This opportunity cost is known as the cost of capital. This is not the only way to calculate the discount rate, however. Businesses who are looking at how to invest their money take into account something called the weighted average cost of capital. We will explore this issue in a future article.
Read more here:
- Warren Buffett and Charlie Munger: Building a Circle of Competence
- Warren Buffett: Lessons From 6 Periods in the Stock Market
- Mohnish Pabrai: What Investors Can Learn From EntrepreneursÂ
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