The discounted cash flow (DCF) model is used to value stocks. The metric provides us with an idea of the value of a stock over the period of an investment, but it can be a tricky one to calculate.
Why use the DCF?
There’s little consensus on the right way to value a share. To start, there are a host of metrics, including the price-to-earnings ratio and the enterprise-value-to-EBITDA ratio.
But these are quite simplistic and tell us little about a stock’s future prospects. They also require us to compare metrics across sectors to understand whether a stock is to be considered ‘cheap’ or not.
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The DCF can offer a better way to understand a stock’s value than these near-term valuation metrics, but it does require me to make estimates about future cash flows.
What is the DCF model?
Essentially, the DCF model is a valuation method that estimates the value of an investment using its expected future cash flows.
In conducting a DCF analysis, as an investor, I must make estimates about cash flows over a given period — in theory the length of my planned investment.
But here’s the discounted bit. Each year’s predicted cash flow is then divided by one plus the ‘discount rate’. The discount rate is applied because £1 in next year is worth less to me than £1 now — it’s the time value of money.
It can get complicated, so thankfully there are calculators online to help me. But by adding together DCFs over the investment period, I can come to a net present value, which in turn is divided by the number of shares.
The final figure provides me with an indication of how much each share should be worth according to the data I’ve used.
Using the DCF model now
The vast majority of bourses are down over 12 months. The FTSE 100 is an outlier because it’s been pushed upwards by surging resource stocks that are well represented on the index. But the truth is, most stocks appear cheaper today than they did a year ago.
However, this correction creates opportunity. I need to be aware that stocks often lose value for a reason. But I’d rather invest in a weak market than a strong one as I think I stand a better chance of finding truly undervalued stocks.
So, this is where the DCF model comes in.
By using the metric, I can develop an understanding as to which stocks are actually undervalued, and which ones are cheap for a reason.
For example, a DCF calculation on Rolls-Royce and Lloyds, with a 10-year exit, suggests they could be undervalued by 45% and 60% respectively.
Yes, the DCF model has its pitfalls, as forecasting cash flow over 10 years for these two firms isn’t easy. However, the calculations are certainly more illuminating that a price-to-earnings comparison.
