An Introduction to Discounted Cash Flow Analysis

This article details discounted cash flow analysis and how it is used to calculate the value of companies. Discounted cash flow arithmetic is essentially a way to size up a company numerically, such as the discount price of a stock. Professionals as well as academic people use this as their base method for value investing and calculating value, numerically.

Discounted cash flow is another way to express the time value of money in terms of perpetuities which is what stock investments are. Corporations are individual entities that have an infinite lifespan as far as the arithmetic is concerned. Because they live longer than the founders of a corporation; they are known as perpetuities as opposed to bonds and annuities; which are not perpetuities.

Calculation

Discounting cash flows is a simple process. It's the variables themselves that can be hard to figure because of the ambiguity of the defining of them.

We will use free cash flow as the cash flow being discounted. Free cash flow generated by the company is an algorithm of the cash flow statements, this is the cash flow that is free for new investments and sinking funds. Let's say company A generates $100 million this year; year 0. Projections for year 1 are $100 million; projections for year 2 are $200 million; and projections for year 3 are $300 million.

Now not taking into account the cost of capital which is the discount rate used to discount these cash flows; we can say that in year 3 the company will have tripled its free cash flow. Let's also assume the company has a 100 million shares outstanding. $300 million/100 million shares=$3/share. This would be the price of the stock in year 0 if capital could be raised for free and free cash flow was $300 million in year 0. However, there is cost of capital factor which is the denominator. Let's assume this rate is 7%. Now what would the price per share be just taking into account year 3 ?

$300 million/(1+.07)3    /100 million shares    = $244.9/100 million shares = $2.45/share

This 7% cost of capital discounted the year 3 future cash flow to a stock price of $2.45. Obviously this example is simplified for the sake of introduction.

Cost of Capital

However, notice how the cost of capital as it goes higher will eventually erode the numerator which is the free cash flow. This is because the time value of money concept which holds that no capital is exempt to the cost of capital. Calculating a companies cost of capital is a good estimate; because it can't always be precise. Normally, it is a weighted average of the company's bond ladder. A simple average of the interest rates charged by the bonds would be misleading because of the bond ladder of maturities by year.

It should be noted that this method of discounting cash flow is the most widely used; however, there are alternate methods. The same concept is used in discounting cash flows with dividends. A dividend rich company can be discounted by their dividends alone.

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