Before you invest in a company, it's crucial to look at certain important factors. Different methods exist for checking a company's financial health and predicting possible returns to figure out a fair share price. One useful method is to focus on the company's cash flow. This means evaluating how much money the company has at the end of the year compared to the beginning of the year.
The discounted cash flow model (DCF) is a common method for determining the overall value of a company. By employing the DCF to assess a company, you can determine the appropriate price for its shares of stock.
The DCF is known as an "absolute value" model because it relies on objective financial data to evaluate a company, rather than comparing it to other firms. Another widely accepted absolute value model is the dividend discount model (DDM), although it may not be suitable for all companies.
The DCF formula is a bit more intricate compared to other models like the dividend discount model. Here it is:
Present value = [CF1 / (1+k)] + [CF2 / (1+k)2] + ... [TCF / (k-g)] / (1+k)n-1]
It might seem a bit complicated, but let's break down the terms:
CF1: The money you anticipate receiving in the first year
CF2: The money you expect to receive in the second year
TCF: The final expected cash flow, representing the overall estimate. This is typically an approximation, as predicting anything beyond five years is uncertain.
k: The discount rate, also referred to as the required rate of return.
g: The anticipated rate at which the company is expected to grow.
n: The count of years considered in the model.
There's a simpler way to understand this.
Let's take a look at a fictional company, Dinosaurs Unlimited. Assuming we're projecting for five years with a 10% discount rate and a 5% growth rate:
If Dinosaurs Unlimited has a current cash flow of $1 million, the discounted cash flow after one year would be $909,000, considering the 10% discount rate.
Over the next five years, with a 5% annual growth, the discounted cash flow figures would be:
Year 2: $867,700
Year 3: $828,300
Year 4: $792,800
Year 5: $754,900
As mentioned earlier, the terminal value is assumed to be three times that of the fifth year, totaling $2.265 million. When you add all these figures, the calculated value for Dinosaurs Unlimited is $6.41 million. Now, if Dinosaurs Unlimited were a publicly traded company, we could assess whether its share price is fair, too expensive, or potentially a bargain.
Let's say Dinosaurs Unlimited is currently trading at $10 per share, with 500,000 shares outstanding, resulting in a market capitalization of $5 million. This suggests that the $10 share price might be on the lower side. As an investor, you might be willing to pay nearly $13 per share, based on the value derived from the DCF.
Recent accounting scandals have emphasized the significance of using cash flow as a measure to determine accurate valuations.
However, it's important to be cautious with cash flow, as it can be deceptive in certain situations. For instance, if a company sells many of its assets, it might show positive cash flow but could actually be of little value without those assets. Additionally, it's crucial to consider whether a company is hoarding cash or actively reinvesting in its own growth.
It's usually more challenging for companies to manipulate cash flow in their financial reports compared to profits and revenue.
Similar to other models, the discounted cash flow model's accuracy depends on the quality of the input information. Obtaining accurate cash flow figures can be challenging. Additionally, it's a more complex calculation compared to simpler metrics like dividing the share price by earnings. If you're willing to put in the effort, it can be a useful tool to assess whether investing in a company is a wise decision.
The discounted cash flow (DCF) and residual operating income (ROPI) are both ways to assess the value of a business. However, ROPI considers information from the balance sheet and income statement, including accrual accounting data, while DCF does not take into account the impact of accrual accounting.
Stock-based compensation (SBC) can make a company's value appear higher when using discounted cash flow (DCF) calculations. DCF doesn't consider accrual-based income, and there isn't a widely agreed-upon method to address SBC when measuring cash flow. SBC is often treated as a non-cash expense, similar to depreciation, in DCF, even though it eventually becomes a real cost for investors.
