The Discounted Cash Flow (DCF) method of stock valuation
Beginner Stock Market Investing, Stock Market Investing Strategies
For many people, the concepts of the time value of money and discounted cash flows are frightening and confusing and they believe that these ideas should be best left to financial whiz kids or mathematicians. It is true that a lot of DCF applications require complicated formula and financial modeling but, if you take the trouble to understand the basic concepts which are relatively straightforward, you can perform back of the envelope calculation using these techniques.
DCF is a convenient techniques that can be used to value small businesses and companies that are not publicly held. It takes a stream of future cash flows (or Earnings before Interest, Depreciation, Taxes and Amortization because EBIDTA is a reasonable surrogate for cash generated from operations) and discounts them back to a present value based on the company’s weighted average cost of capital. The aggregate of all these future discounted cash flows is the present value of the business. This merely represents the principle that money as a time value which is pretty obvious when you consider that a sum of money you receive today is worth more than a sum of money you receive next year and because you can earn interest on it in the interim period. If you are performing advanced analysis, you would discount the valuation for such factors as small-business risk or the lack of liquidity.
While the DCF is a highly reliable method for valuing private or unlisted businesses, it is also an excellent way of examining the price at which publicly traded stocks trade. It is not uncommon, especially in the United States, for relatively young businesses with high capital costs and relatively uncertain earnings to trade at P/E ratios that are higher than the DCF valuation. This can also be true for well-established companies with very high P/E ratios. Because these high ratios are not sustainable indefinitely, you may well find that at a particular point in time, that the P/E ratio which is the market perception of value may exceed the DCF value of market capitalization by such a high factor that you may regard the risk of buying at the current price as unacceptable.
If you try just a few DCF calculations on your own, you will easily understand why the cost of capital is so crucial to the DCF valuation. Large well-established companies tend to have costs of capital that are relatively stable and do not fluctuate much. For smaller companies, this figure can fluctuate significantly over different economic cycles and interest rate regimes. The higher the cost of capital, the lower will be the DCF valuation. For companies, with a market capitalization of less than $500 million, it would be prudent to load the cost of capital by about 3% to reflect the higher risk of investment. The credit crunch of the year 2008 in demonstrates this when smaller businesses that had been able to access bank credit at around 8% suddenly found themselves having to pay up to 14% to sources like hedge funds for scarce capital. For a company with annual cash flows of $10 million in growing at around 12% per annum. The decline in DCF valuation as a result of this hike in cost of capital would drop by as much as 30%.
Tags: beginner investing, Beginner Stock Market Investing, DCF, discounted cash flow, investing for beginners, Stock Market Investing, stock valuation, valuation