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Discounted cash flow explained

Discounted cash flow explained

The value of an investment can essentially be seen as the future benefits it will bring. For stocks, this will effectively be the cash flows that it will generate for the investor. The intrinsic value is one of the most widely accepted valuation methods in finance, as opposed to book or market value. The intrinsic value is generally considered to be the future cash flow production of a company, discounted to their present value, the calculation being known as the Discounted Cash Flow (DCF) valuation.

The DCF method states the company is worth all the cash that it could make available to the investor in the future. The cash flows are discounted because cash flows in the future are worth less than cash flows today. The time value of money concept holds that money today is worth more because that money can earn interest, therefore money is worth more the sooner it is received. Put another way, money in the future is worth less because inflation has diminished its buying power.

To perform a basic DCF calculation, an estimation of free cash flows for a projected period must be ascertained. The number of years of cash flows in a projection period may be influenced by the competitive position of the company or how accurate one can project the business performance of a company into the future. Optimally the forecast period can be 5-10 years. Free cash flows are the amount of cash a company has left from its operations and are basically what remains after deducting operating costs, taxes, net investment, and changes in working capital from revenue.

Once the free cash flows are established for the projection period, a calculation of what they are worth today is required. An appropriate discount rate must be used to calculate the net present value of the cash flows. A widely used approach is the weighted average cost of capital (WACC), a blend of the cost of equity and the after-tax cost of debt.

The calculation of cost of debt would essentially be the rate the firm pays its banks and bondholders. The cost of equity is basically the return the investors require from the company, or what it costs the company to maintain a share price that satisfies investors. The Dividend Capitalisation Model and Capital Asset Pricing Model are generally used for cost of equity calculations. A firm does not have an infinite life and cash flows cannot be estimated forever. As stated above projections periods are generally 5-10 years. Therefore a terminal value is calculated. The combination of the discounted cash flows and the terminal value result in the DCF valuation.  

A simple method of calculating the terminal value is to take the final projected cash flow times 1 plus a long-term growth rate, and then divide it by the discount rate less the growth rate. While this sounds complicated, it just means that the last cash flow projected will remain stable and continue to grow at a future growth rate, the formula provides for this. If the input assumptions are in a correct range, the DCF will produce the closest thing to an intrinsic stock value, which can asses whether there is a trading opportunity.

Anthony Galliano is the chief executive of Cambodian Investment Management.
[email protected]

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