Some considerations in DCF stock valuations
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
You may have often wondered how stock analysts come up with estimates of fair value and why there is such a range of values for any company. After all, an objective measurement should not result in these kinds of variations. The concert is of course that there are a whole lot of different ways of valuing companies and even if a common method such as the discounted cash flow [considered one of the most reliable] is used, much depends on the exact estimates that are used. However, if you teach yourself the basics of DCF stock valuation, you can cross check these valuations to determine which one you should rely on.
In the simplest possible terms, DCF valuation tries to estimate the value of a company based on the amount of free cash it is going to generate in the future. In other words, the value of a company depends on the amount of cash that could be made available to investors in the future. It is termed as discounted because of the adjustment for the time value of money. The underlying premise is that cash available today is worth more than cash available next year because it can be immediately invested to earn a return.
Even with discounted cash flows, there are several valuation approaches such as the Dividend Discount Model and the Free Cash Flow. No matter what method you pick, there are a number of advantages if you get familiar with discounted cash flow valuations. As already mentioned, it gives you a reality check on the prices established by different analysts. The process of DCF valuation requires you to systematically examine any important factor that may affect the future of the company such as sales and profits.
It also provides you with a factor for your risk because of the discount rate. Discount rates are generally fixed by taking a risk free return rate [such as the rate on US treasuries which are considered to be risk-free investment] and adding to it a premium for the risk on a particular stock. In order to establish the risk premium, you may also have to take into account factors such as share price risk and the weighted average cost of capital.
When you start on a DCF analysis, the first thing that you would have to settle it is how far into the future you wish to take your analysis and hence the period for which you would like to consider cash flows. There are a number of different scenarios which you would need to take into account. If your company is in a high-growth phase where it is growing faster than the economy, it is quite likely that in this growth phase, any new investments that it undertakes to generate returns that are in excess of the cost of capital. You’ll therefore need to make an educated guess as to how this phase will last before the company returns to a mature slower growth cycle. You should keep in mind that the timeframe of your DCF model should normally be between five and 10 years. Anything longer will be that much more unreliable.
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