Discounted cash flows for dummies

Performing a DCF analysis is a subject about which I have meant to write for some time. It is the culmination of the search for an objective means of valuing companies based on the total profit they will produce in the future. Various equations exist for calculating a company’s net present value. I will present one of the simpler equations for two reasons: it is easier and it involves fewer assumptions that could be wrong.

For a handy spreadsheet to calculate the present value of future cash flows, given expected growth rates and current cash flows, see this workbook (Excel format).

Performing a DCF analysis is relatively simple. We take the current profit per share (as measured best by free cash flow to equity, FCFE). Free cash flow to equity can be difficult to calculate, so free cash flow (FCF) can be used instead. If you wish to perform a quick and dirty DCF, you can use earnings instead of FCF, but this is generally not a good method.

The standard means for conducting a DCF is to take the present profit per share and then project assumed changes in that profit into the future. We use an interest rate as the discount rate to account for the time value of money (there are many different approaches for selecting the correct discount rate). Therefore, the further in the future a dollar is earned, the less it is worth today. This is because time has value. In the workbook I use 8% as the discount rate. Many people use the rate on the 10-year treasury bond. If you do that, use a long-term average of yields, otherwise your calculations of current value will change drastically over short time periods as the interest rate fluctuates. Also, you should add a risk premium onto the risk-free rate if you use it as the discount rate. A simple and theoretically defensible method would be instead to just use the long-term return on equities as the discount rate, or even the expected return given current valuations (see Rob Arnott’s work on expected returns given valuations). If we can expect the stock market over the next 50 years to appreciate around 8% per year, we would not choose an individual stock over the index unless that stock could be expected to return greater than 8% per year.

A DCF analysis is often conducted out towards infinity. In other words, given our assumptions, we figure the present value of the company infinitely far in the future. If a company were to increase its profit every year at the risk-free rate, than its profit in today’s dollars would remain the same infinitely far in the future. This never happens, so besides a period of relatively quick growth, we introduce a final growth rate for each company that is less than the risk-free rate. For this final growth rate I use the long-run inflation rate. In essence, we assume that after a period of growth the companies do not grow except in nominal returns.

‘Growth’ investors like to say that if you buy a really great, fast growing company, it really does not matter how much you pay for it. They are actually right. As I will discuss later, the faster a stock grows, the more important its growth rate becomes to its investment value. At the extreme, a company that will forever grow earnings at a rate at or above the risk-free rate will be worth an infinite amount of money, and thus its price will always be less than its true value. Conversely, the investment value of a company with zero growth will be determined purely by its current price.

There is much more to DCF analysis than this. We can model changing leverage (debt) rates, changing ROC rates, and just about anything else we want in a DCF analysis. One key, however, is to remember that a DCF analysis is only as good as our assumptions. As I will showed in the article Regression to the Mean, our assumptions are often more inaccurate than we believe.

Disclosure: This article was originally published elsewhere.

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