The discounted cash flow method is one way investors determine the value of a stock. In this method, an analyst uses future expectations of cash flow to estimate the total value of the equity investors place into a company for a given projection period. This is usually five or 10 years. The DCF method adjusts future cash flows to account for interest and lost opportunities. This value is often different than the stock's actual price due to market conditions and speculation.
Project and calculate free cash flows. This is the cash that the company is expected to have left over in each accounting period after financing its basic operations and major capital investments. To determine the free cash flow, subtract projected capital expenditures -- long-term asset purchases -- from the business's expected cash flow from operations. It is also possible to determine free cash flows from the income statement, although this method is slightly more complex.
Determine the cost of capital. In the discounted cash flow method, the cost of capital is a weighted average based on the firm's balance of capital, which is how much of its money comes from lenders and investors. The cost of equity is determined by the expected performance of investments in the business's industry sector. A business's credit rating determines its cost of debt, which is the interest a business expects to pay on its loans excluding taxes the business will save from taking an interest expense deduction. Multiply the cost of equity by the proportion of equity to the firm's total capital, which is the sum of both equity and debt. Similarly, multiply the cost of debt by the proportion of debt to total capital. Add these results to obtain the discount rate, or weighted average cost of capital.
Calculate the company's final value beyond the projection period. This is called the company's terminal value. There are several different ways to do this, but the most straight-forward is to assume that the company's free cash flow will continue to grow at a steady rate forever. Use the inflation rate adjusted for industry and economic factors. Multiply the free cash flows of the projection's final period by the growth rate to get the expected cash flow growth rate, and add this number to the free cash flows of the last period to find the numerator. Divide this numerator by weighted average cost of capital minus the growth rate, to find the terminal value.
Calculate the intrinsic value, which is the total value of the firm, using free cash flows and terminal value. First, discount the free cash flows for each year to the weighted cost of capital -- divided each year's FCF projection by one plus the discount rate, raised to the number of years so far. Discount the terminal value by dividing the terminal value by the one plus the discount rate, raised to the total number of years in the projection. The sum total of all of the discounted free cash flows and the discounted terminal value is the intrinsic value of the firm.
Compare the intrinsic value to other investments to arrive at the estimated cost of equity. When an investor chooses a given firm over other opportunities, he forgoes the intrinsic value of those opportunities in exchange for the value from the chosen investment. The difference between other investments' intrinsic values and the chosen investment's intrinsic value is the estimated cost of equity. This is the amount of potential income lost or gained in the investment choice.
Check with financial databases and news outlets to find comparison values for the industry sector. Use historical inflation rates to accurately determine the expected growth rate.
The calculations in the DCF method are only as good as the projections that inform them. Inaccurate cash flow expectations can result in incorrect terminal and intrinsic values.
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