Discounted cash flow model can be used for financial valuation of a project, company, stock, bond or any income producing asset.

Discounted cash flow is a financial valuation method that calculates the value of an investment based on the present value of its future income or cash flow. The method helps to evaluate the attractiveness of an investment opportunity based on its projected future cash flows.

Free Cash flow to the firm (FCFF) means the amount of surplus cash flow available to a business after a it pays its operational expenses like inventory, rent, salaries etc. and also invests in fixed assets like plant and machinery, property etc. Cash is an important element of business. It is required for business functioning; some investors provide more value to cash flow statements than other financial statements.

Free cash flow is important metric as it tells about the company’s ability to deploy capital in future projects. Without cash, it’s tough to develop new products, make acquisitions, pay dividends, buyback shares and reduce debt. Also, as cash is difficult to manipulate compared to other variables, FCFF is more reliable indicator of a company’s performance than net earnings.

DCF model can be used for valuation of a project, company, stock, bond or any income producing asset. The DCF method can be used for the companies which have positive Free cash flows and these FCFF can be reasonably forecasted. So, it cannot be used for new and small companies or industries which have greater exposure to seasonal or economic cycles.

To use the Discounted Cash Flow Model to Value Stock:

Step 1 : Calculate the Free Cash flow to the firm

Step 2 : Project the future FCFF – You need to project the future FCFF for the next couple of years. You can analyze the historical data to understand the past FCFF growth trend. However, relying on historical data only won’t give you the right result, so consider the present financials as well as future potential of the company while projecting the growth rate. When conducting a DCF analysis, investors and businesses must make estimations for future cash flows and the future value of the investment. For instance, a company considering a new business acquisition must estimate the future cash flows from expanding its processes and operations with the acquisition. The estimates the company makes can help determine if the investment is worth the cost of the acquisition.

Step 3 : Discount the FCFF — Calculate the present value of this cash flow by adjusting it with the discount rate. Discount rate is your expected return %. The discount rate is one of the most important elements of the DCF formula. Businesses need to identify an appropriate value for the discount rate if they are unable to rely on a weighted average cost of capital. Additionally, the discount rate can vary depending on a range of factors like an organization’s risk profile and the current conditions of capital markets. If you are unable to determine a discount rate or rely on a WACC value, an alternative model may be more beneficial and accurate.

Step 4 : Calculate the Terminal Value — It is the value of the business projected beyond the forecasting period. It is calculated by assuming the constant growth of a company beyond a certain period known as terminal rate.

When valuing a business, the annual forecasted cash flows typically used are 5 years into the future, at which point a terminal value is used.  The reason is that it becomes hard to make reliable estimates of how a business will perform that far out into the future. There are two common methods of calculating the terminal value:

• Exit multiple (where the business is assumed to be sold)
• Perpetual growth (where the business is assumed to grow at a reasonable, fixed growth rate forever)

Step 5 : Add discounted FCFF with Terminal value and adjust the total cash and debt.

Step 6 : Divide the Figure calculated in Step 5 by the outstanding number of shares to find out the DCF Value.

Step 7 : Adjust the Margin of Safety to find out the Fair value. Margin of Safety provides discount for uncertainties in the business.

When assessing a potential investment, it’s important to take into account the time value of money or the required rate of return that you expect to receive.

The DCF formula takes into account how much return you expect to earn, and the resulting value is how much you would be willing to pay for something to receive exactly that rate of return.

• If you pay less than the DCF value, your rate of return will be higher than the discount rate.
• If you pay more than the DCF value, your rate of return will be lower than the discount.

The DCF formula is used to determine the value of a business or a security.  It represents the value an investor would be willing to pay for an investment, given a required rate of return on their investment (the discount rate).

When using the DCF analysis, determine the discount rate and have estimates for future cash flows. Apply these values in the DCF formula to create a future outline that details expected returns. If the results appear at or above a company’s initial projections for future cash flows, then investing can be beneficial. However, if the discounted cash flow formula results in a value below a company’s projected future returns, it may consider alternative investments.

References:

1. https://www.finology.in/Calculators/Invest/DCF-Calculator.aspx
2. https://corporatefinanceinstitute.com/resources/knowledge/valuation/dcf-formula-guide/
3. https://www.indeed.com/career-advice/career-development/discounted-cash-flow