When any company buys an asset, the expectation from the asset is to generate future revenue in the form profit and cash inflow for the business. So, companies often base their decision of purchasing an asset on the future expected revenue, profit and subsequent cash inflow.
Similarly, when you buy stocks of a company, the underlying assumption is that its value will grow over time and fetch dividend income apart from capital appreciation. Often, a determining factor behind the purchase of a stock is thediscounted cash flow (DCF).
What is DCF in finance?
The DCF approach is a valuation technique whereby using the time-value of money, the future cash flow attached to the stock/asset is calculated to reveal its present value. The fair value of the investment refers to the present value of all the projected cash flows.
For example, if we calculate discounted cash flow regarding a stock, it would involve calculating the dividend amount and the amount expected on sale (of stock). Then, you can decide if the resulting present value is greater or lower than the price currently being quoted on the stock exchanges.
How to calculate DCF of stocks to invest in?
- Calculate the free cash flow to the firm (FCFF) for the current year
- Use it to project future FCFF and a terminal value
- Discount the FCFF and terminal value using a discount rate that corresponds to the level of risk taken to get the enterprise value
- Add the cash/bank balance and reduce debt outstanding from enterprise value to arrive at an equity value
- Divide the equity value by the total number of outstanding shares to get intrinsic value on a per share basis
You can adjust the Margin of Safety (MoS) percentage (as per individual preference, if required) on this intrinsic value to arrive at a fair value according to you.
What is the importance of discounted cash flow in finance?
- It helps potential shareholders to determine the intrinsic value of a share
- DCF allows you as an investor to choose between several options in different industries
- Discounted cash flow allows you to gauge the expected return on a possible investment or even an existing one
- It considers the economic life of an investment and its returns
DCF could be a way to judge the fair value of your investment
DCF is a useful way to calculate the intrinsic value of your investment. It helps you to ascertain if your shortlisted stocks to buy of a company are worth its price. Comparing the intrinsic value (as adjusted by a margin of safety in accordance with individual preference) and the quoted stock market price will help determine the action (buy, sell, hold) required to be taken on the existing/potential investment.