The Discounted Cash Flow (DCF) is a popular valuation model that uses the company’s future cash flows to assess if the stock is a worthy investment. Investors discount the company’s future cash flows to see if their projected value for the stock is greater than its current ask. The DCF-model is a great tool for the investor’s toolkit because it allows investors to base their valuation on the company’s future performance, rather than historical performance.
In order to calculate the DCF, you need to either calculate or identify projected cash flows for the company for however many years the investor chooses, as well as find the Weighted Average Cost of Capital (WACC) for the company to be used as the discount rate. With this data, you simply calculate the present value of each future cash flow, discounted by the company’s WACC and time.
DCF = CF1/(1+r)^1 + CF2/(1+r)^2 + …. CFn/(1+r)^n
Suppose a Company ZYXW has an Enterprise Value of $10,000,000 with 1,000,000 shares outstanding, meaning the stock is currently trading at $10/share. Additionally, we know that ZYXW’s cash flows are expected to increase by 7% per year for the next five years and that the company has a WACC of 5%.
From here, the investor will take the present value of each of each of the company’s next 5 Cash Flows and discount them by the WACC.
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From here, the investor will take the sum of all of the discounted cash flows to come up with their projected value for the company, which in our case, is $9,893,598. When divided by the number of shares outstanding, we derive a share value of $9.89. This means that Company ZYXW may be very slightly overvalued, as the current share price from our model is less than today’s share price.
Despite the clear benefits to tying valuation to future cash flows, the Discounted Cash Flow model has distinct disadvantages that can leave the investor vulnerable to errors from both anticipated and unanticipated factors. The primary criticism for this model is that it requires the investor to correctly (or closely) project a company’s future earnings. Projections that are too high will result in the investor thinking that an investment will be more profitable more profitable than it is, while too low of projections cause the investor to miss value investments.