Discounted Cash Flows (DCF) – an important valuation tool

Last time, we saw that just PE ratio is not enough for us to understand the true valuation of the company. There are many other aspects you need to look at when choosing a company for investment. One of them is called as Discounted Cash Flow (DCF).

DCF is the most complete valuation method. It consists of predicting a company’s expected cash flows and then discounting them by your expected  rate of return from the stock to its present value.

If the value obtained from DCF valuation exceeds the present market price of the stock, the stock can be considered to be a bargain. If it is less than the current price, then sell the stock.

For this, you need the following 4 factors:

• Free cash flow: Free Cash flow is the amount of money that can be withdrawn from business without affecting the company’s business. It is responsible for determining the company’s investment worth. However calculating it is very complex, so instead you can use net cash generated by the company in its last year of operation. You can get this figure from the company’s balance sheet.
• Discounted rate: It is the rate of return that you think the stock will generate. Keep it realistic to prevent disappointments later on. A rate 15% can be considered to be realistic and is twice the rate of risk-free return.
• Period: To calculate DCF, you need to find out the life expectancy of the company or the period by which you can expect to recover your money. If you are not able to estimate this period, you can assume it to be 5-10 years.
• Residual worth: Usually lifespan of most businesses exceed 5-10 years than what we had estimated above. Hence it becomes essential for you to assign a value to remaining life span of the company. This can be achieved by adding the company’s current net worth or asset value to previous year’s cash flow.

You can then enter these figures in an Excel sheet to get the figure that the company’s shareholders will earn as net cash from its operations for the period under consideration. From this figure, the company’s present debt is deducted and the balance is divided by the company’s equity to get the DCF.

Calculating the Value of the Share

In the last article, we saw that in order to earn profit in stock markets, the price at which you buy the share should not exceed its value. So it is very  important you calculate the value of the share.

Calculating the value of the share: First you must begin by reading through financial statements of the company. Acquaint yourself with the finer nuances of the stocks.

Then you need to understand the valuation methods of the share. There are 2 methods to do that.

First Method: Calculate the net liquid assets per share. It is done by subtracting the liabilities from the current assets and dividing the result by number of shares.

Net liquid assets per share = Current assets –liabilities / number of shares

Current assets include  cash, debtors, liquid investments etc

The great investor Warren Buffet recommends paying not over 2/3 this figure for a share.

Second Method: Consider the PE (Price to earnings) ratio. It is calculated by dividing the market price of the share by Earnings per share (EPS).
 
PE ratio = Market price of a share/ Earnings per share

If the PE ratio is 1, you can say the share has fair valuation. If it below 1, it is undervalued and if it exceeds 1, it is overvalued.

In the next part, we’ll take a closer look at PE ratio.

Related Link: The Mantra to Stock Market Success

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