Using cash flows is the best way to value a business.
There’s little consensus on the right way to value a share — except that it’s part art, part science.
Compare it with valuing a piece of artwork such as Andy Warhol’s “200 One Dollar Bills” silkscreen, which recently sold for a staggering $43.8 million (£28.5 million). How would you justify that price when the materials probably cost 200 one-dollar bills?
To start, you could attribute much of the value to the Warhol name. Then you’d probably consider the meaning to the buyer, the piece’s importance relative to other works, and what someone else might pay for it down the road.
Some rely on “relative” valuation, comparing multiples such as price-to-earnings with the same metrics for competitors, but Fools should prefer to focus on the company’s underlying fundamentals — like cash flow and earnings — rather than where the share may trade relative to competitors.
What is discounted cash flow in simple terms?
More often than ever, earnings per share is manipulated by one-time charges, non-IFRS accounting, and subjective management teams that do all they can to make earnings look better.
But cash is a fact.
By estimating how much cash a company will make available to shareholders after it invests in new assets and satisfies other obligations (i.e., to lenders and pensions), we can begin to determine how much that future cash is worth today — and can then estimate the intrinsic value of a share. This is known as discounted cash flow, or DCF, analysis.
How to calculate DCF
To illustrate, say your friend Steve offered you £1,000 today or the promise of £1,000 five years from now. You’d be foolish (lowercase “f”) not to take the £1,000 today because you can put that money to work earning interest — and assuming inflation follows history, £1,000 will buy more goods today than it will in five years.
But what if Steve asks how much you’ll pay him today for his promise of £1,000 five years from now (just as you pay for the promise of a company’s future cash flows)?
This is a tougher question. You need to factor in expected inflation over the next five years in addition to a decent rate of return relative to Steve’s trustworthiness (for this exercise, we’ll consider his word his bond). Let’s say the “discount” rate that we believe fairly compensates us for expected inflation and for the risk of lending to Steve is 6%.
The equation to determine how much you’d lend Steve today would be:
Future value / (1 + discount rate)number of years
or £1,000 / (1.06)5 = £747.26
So, the amount we should pay today for Steve’s £1,000 in five years is £747.26.
Taking it a step further, if Steve said he’d pay us £1,000 in year five and another £1,000 in years six and seven, now how much would we pay today?
| Time of cash flow | Amount of cash flow | Formula | Present Value |
| Year 5 | £1,000 | (£1,000 / (1.06)5 | £747.26 |
| Year 6 | £1,000 | (£1,000 / (1.06)6 | £704.96 |
| Year 7 | £1,000 | (£1,000 / (1.06)7 | £665.06 |
| Sum | £2,117.28 |
Put simply, you would give Steve £2,117.28 today for the promise of three £1,000 payments delivered in years 5 through 7.
This second example is closer to discounted cash flow valuation: We estimate future cash flows, discount that cash at a rate that adequately reflects its risk, and come to a fair value for the cash today.
Two kinds of free cash
Unfortunately, there’s no “Steve” in the share market telling us exactly how much he’ll give us down the road. So, how do we determine which cash flows to measure?
When valuing a company, we target the cash flows left over — the “free” cash — after the company has invested in projects to further grow the business (i.e., capital expenditures and acquisitions). In other words, this is the cash that could be paid out to investors, and thus, we can use it to measure value. There are two major types of free cash: free cash to firm and free cash to equity.
Free cash flow to firm (FCFF) is what’s left over before the company has paid interest to debt holders and after corporate reinvestment needs.
- How to calculate FCFF: Start with after-tax operating income, add back non-cash depreciation expenses, and subtract capital expenditures and changes in working capital (current assets minus current liabilities).
- What’s the discount rate? Because you’re factoring both the cost of debt and equity for the firm, you discount FCFF at the company’s weighted average cost of capital, a mix of its cost of debt and equity.
- Done. Then what? Back out all non-equity commitments (debt obligations, operating leases) and add back cash to arrive at the equity value — the number we care about as equity investors. Divide that amount by the number of shares outstanding to get the fair value per share.
Free cash flow to equity (FCFE) is cash left over after all non-equity obligations have been met.
- How to calculate FCFE: Start with net income, add back non-cash depreciation expenses, and subtract capital expenditures and changes in non-working capital. Any new debt proceeds received by the company could theoretically be paid out to equity holders as a dividend, so that should also be added to the calculation.
- What’s the discount rate? FCFE is discounted at the company’s cost of equity, traditionally measured by the capital asset pricing model, or CAPM, which factors in a risk-free rate (for valuations done in Sterling, this is the 10-year gilt rate), the investment’s beta (to measure relative risk to the market), and the equity risk premium (compensates investors for extra risk with shares over bonds).
- Done. Then what? Divide the equity value by number of shares outstanding to get the fair value per share.
Valuation models using either free cash flow to firm or equity should arrive at the same conclusion, but depending on the type of company being analysed, one model can be “better” than the other.
For instance, companies with fluctuating levels of debt make projecting future equity cash flows difficult, so it’s more prudent to value the entire firm using free cash flow to firm and back out all non-equity obligations. On the other hand, for companies with no debt or stable debt ratios, free cash flow to equity valuations can be much clearer.
Play with numbers
Prudent Fools tests various scenarios for each company’s projected free cash flows to determine a range of potential values. Valuing a company to the penny, as many City analysts do, is an exercise in futility because it assumes you’ve perfectly modelled the future. Don’t be so confident to think that you know a company’s exact standing five years from now or more.
The ultimate objective of valuing a share is to make sure you’re paying at least a fair price for your investment — one that should generate attractive returns — and obtaining a suitable margin of safety. Overpaying for a share is one of the most common causes of permanent loss of capital.
Advantages of using DCF models
Valuing a business using the discounted cash flow approach has a lot of advantages compared to relying on relative valuation methods such as the P/E ratio. Some of the biggest include:
- Detailed Analysis – At the heart of a DCF model lies the assumptions and expectations of an underlying business. This allows investors to factor in crucial pieces of information that could significantly impact the value of a business in the long term.
- Estimates Intrinsic Value – Unlike relative valuation metrics, a discounted cash flow model will produce a precise share price of what a business should be worth. It doesn’t require a peer group or industry to compare against, allowing for the valuation of businesses with unique operations or minimal competition.
- Compatible with Unprofitable Companies – A significant disadvantage of using the price-to-earnings ratio is the inability to value unprofitable businesses. A discounted cash flow suffers from no such limitation as projections can be made along a firm’s expected path to profitability to determine its discounted value today.
- Considers Future Growth – While there are variations of the P/E ratio that look at future earnings growth, they are far less comprehensive compared to a DCF model, which also takes profit margin expansion or contraction into account for much longer periods. In other words, a discounted cash flow model allows analysts to bake in growth expectations into their valuation.
Disadvantages of using DCF models
The advantages of discounted cash flow models seem to fix a lot of the shortcomings of relative valuation metrics. However, even these more detailed models are far from perfect. They also have plenty of downsides that can make them unpopular and prone to error.
- Dependent on Assumptions – The biggest issue surrounding DCF models is the high level of reliance on certain assumptions. In many cases, these assumptions can fail to materialise, making an intrinsic valuation highly inaccurate. DCF models suffer from the classic garbage in, garbage out problem.
- Complicated – An earnings multiple can be calculated in a few seconds. However, a DCF model can take hours or even days to build due to the higher level of detail and research needed to calculate inputs and assumptions.
- Biased Results – The increased level of detail that goes into building a DCF model opens the door to overconfidence bias. As such, investors can make big bets on a valuation without knowing whether or not it is flawed.
- Requires Discount Rate Calculation – A critical requirement of a DCF model is determining an appropriate discount rate. Typically, the weighted average cost of capital (WACC) is used, which requires the computation of the cost of debt as well as the cost of equity. And the latter, in particular, can be complicated to estimate.
Is DCF the same as NPV?
Another commonly used metric used in combination with a discounted cash flow model is the Net Present Value or NPV. While similar, these metrics are not the same.
When calculating the net present value, future cash flow projections are also calculated and discounted back to the present day. However, a key difference is that with NPV, the initial cost of investment is also subtracted.
The NPV is commonly used by businesses to determine whether a project or strategy is worth pursuing. If the NPV is positive, then that suggests a profit will be made. If the NPV is negative, then it’s likely a loss will be made, and therefore, the project is not worth pursuing.
However, just because the net present value is positive doesn’t automatically make something a good investment. Other factors such as timeline, risk, and other opportunities also have to be taken into consideration.
The bottom line
Just as each art appraiser has a slightly different method of valuing art, each investor will have a different formula for valuing shares — but DCF analysis is one solid way to value the underlying business, which in turn helps us make smarter long-term investments.