Discounted cash flow (DCF) valuation can seem like a financial art form that's best left to finance Ph.D.s and Wall Street technical wizards. DCF intricacies do involve some complex math and financial modeling but you can perform "back-of-the-envelope" calculations to help you make investment decisions or value small businesses if you understand the basic concepts.
Key Takeaways
- Discounted cash flow (DCF) is amethod of valuationthat's used to determine the value of an investment based on its return or futurecash flows.
- The weighted average cost of capital (WACC) is typically used as a hurdle rate.
- The investment's return must outperform the hurdle rate.
- DCF is the standard for valuing privately-held companies but it can also be used as an acid test for publicly-traded stocks.
Understanding Discounted Cash Flow (DCF)
Discounted cash flow (DCF) is amethod of valuationthat's used to determine the value of an investment based on its return in the future, referred to as futurecash flows. DCF helps to calculate how much an investment is worth today based on the return in the future. DCF analysis can be applied to investments as well as to purchases of assets by company owners.
The DCF valuation method can be used for privately held companies. It projects a series of future cash flows or earnings and then discounts for the time value of money: One dollar today is worth more than one dollar in the future because the one dollar today can be invested.
Discounted cash flow uses a discount rate to determine whether the future cash flows of an investment are worth investing in or if a project is worth pursuing. The discount rate is the risk-free rate of return or the return that could be earned rather than pursuing the investment.
A discount rate might be the rate for a two-year U.S. Treasury bill. It's not worth pursuing if the project or investment can't generate enough cash flows to beat the Treasury rate or risk-free rate. The risk-free rate is subtracted or discounted from the expected returns of an investment to arrive at the true investment gain so investors can determine whether it's worth the risk.
DCF Uses
A company's own weighted average cost of capital (WACC) over five to 10 years can be used as the discount rate in DCF analysis.
WACC calculates the cost of how a company raises capital or funds. This can be from bonds, long-term debt, common stock, and preferred stock. WACC is often used as the hurdle rate that a company needs to earn from an investment or project. Returns below the hurdle rate or the cost of obtaining capital aren't worth pursuing.
The expected future cash flows from an investment are discounted or reduced by the WACC to factor in the cost of achieving capital. The sum of all future discounted flows is the company's present value. Professional business appraisers often include a terminal value at the end of the projected earnings period.
The typical forecast period is roughly five years but terminal value helps determine the return beyond the forecast period. It can be difficult to forecast that far out for many companies. Terminal value is the stable growth rate that a company or investment should achieve in the long term or beyond the forecast period.
Some analysts might also apply discounts in DCF analysis for small-company risk, lack of liquidity, or shares representing a minority interest in the company.
An Acid Test for Valuing a Public Stock
DCF is a blue-ribbon standard for valuing privately held companies. It can also be used as an acid test for publicly traded stocks. Public companies in the United States may have P/E ratios determined by the market that are higher than DCF. The P/E ratio is the stock price divided by a company's earnings per share (EPS) which is net income divided by the total of outstanding common stock shares.
This is especially true of smaller, younger companies with high costs of capital and uneven or uncertain earnings or cash flow. But it also can be true of large, successful companies with astronomical P/E ratios.
Apple (AAPL) had a market capitalization of $2.85 trillion and a share price of $175 as of February 2022. The company was also generating operating cash flows of around $100 billion in 2021 (approximately $6.70 per share) and had a WACC of 8.7%. We'll assume that Apple can increase its operating cash flow by 10% per year over the 10-year period, a somewhat aggressive assumption because few companies are capable of sustaining such high growth rates over lengthy periods.
DCF would value Apple at around $187.50 per share on this basis or 7% above its stock market price of $175 at the time. DCF provides one indication in this case that the market may be paying a good price for Apple's common stock. Smart investors might look to other indicators for confirmation, such as the inability to sustain cash flow growth rates in the future.
The Importance of WACC on Stock Market Valuations
Doing just a few DCF calculations demonstrates the link between a company's cost of capital and its valuation. The cost of capital tends to be somewhat stable for large public companies such as Apple) but this cost can fluctuate significantly over economic and interest rate cycles for small companies.
The higher a company's cost of capital, the lower its DCF valuation will be. DCF technicians may add a "size premium" of 2% to 4% to the company's WACC to account for the additional risk for the smallest companies below about $500 million in market cap.
The cost of capital for the smallest public companies soared as banks tightened lending standards during the credit crunch of 2007 and 2008. Some small public companies that could tap bank credit at 8% in 2006 suddenly had to pay 12% to 15% for increasingly scarce capital. Let's see what the impact of increasing WACC from 8% to 14% would be on a small public company using a simple DCF valuation.
The company has $10 million in annual cash flow and projected annual cash flow growth of 12% over 10 years.
| Net present value of the company @ 8% WACC | $143.6 million |
|---|---|
| Net present value of the company @ 14% WACC | $105.0 million |
| Decline in net present value $ | $38.6 million |
| Decline in net present value % | 26.9% |
The company is valued at $38.6 million less based on the higher cost of capital, representing a 26.9% decline in value.
Building a Company's Value
DCF valuation can help you focus on what's most important if you're building a small company and hope to sell it one day: generating steady growth on the bottom line.
It's difficult to project cash flow or earnings years into the future in many small companies. This is especially true of companies with fluctuating earnings or exposure to economic cycles. A business valuation expert is more willing to project growing cash flows or earnings over a lengthy period when the company has already demonstrated this ability.
Another lesson taught by DCF analysis is to keep your balance sheet as clean as possible by avoiding excessive loans or other forms of leverage. Awarding stock options or deferred compensation plans to a company's top executives can strengthen a company's appeal to attract quality management but it can also create future liabilities that will increase the company's cost of capital.
How Do You Determine the Correct Discount Rate?
Choosing the appropriate discount rate for DCF analysis is often the trickiest part. The entire analysis can be erroneous if this assumption is off. The weighted average cost of capital or WACC is often used as the discount rate when using DCF to value a company because a company can only be profitable if it's able to cover the costs of its capital.
How Is WACC Calculated?
The weighted average cost of capital takes the relative proportion of debt and equity employed by a firm and their respective costs into account. The WACC formula is;
WACC=(E/V ×Re)+(D/V ×Rd× (1−Tc))
where:
- E=Marketvalueofthefirm’sequity
- D=Marketvalueofthefirm’sdebt
- V=E+D
- Re=Costofequity
- Rd=Costofdebt
- Tc=Corporatetaxrate
How Do You Compute Discounted Cash Flows (DCF)?
DCF calculations begin with a forecast of expected cash flows from an investment over time. You must then choose the appropriate discount rate. The future cash flows are then discounted back to the present by dividing the forecasted cash flows by the discount rate to the nth power where n is the number of periods into the future.
This is most often accomplished with the help of a financial calculator, spreadsheet, or software.
The Bottom Line
DCF valuation isn't just financial rocket science. It also has practical applications that can make you a better stock market investor. It serves as an acid test of what a public company would be worth if it were valued the same as comparable private companies.
Astute, value-minded investors use DCF as one indicator of value and also as a "safety check" to avoid paying too much for shares of stock or even a whole company.
Correction - July 19, 2024: This article has been corrected to state that Apple's DCF value would be greater than its stock market price at the time of calculation.
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GuruFocus. "AAPL."
