Before you invest in a company, you need to research its value. There are ways to assess a company’s financial performance and to find expected returns to reach the objective share price. One of the great ways to value an entire company is by using a discounted cash flow model (DCF).
This method also allows you to know the value of company shares of stocks. Some people call name this method as ‘absolute value’ model. That name comes since the model uses objective financial data to evaluate a company. It does not compare one company with other companies.
The formula
This model owns a little bit more complicated formula than the other models, including the dividend discount model.
Present value = [CF1 / (1+k)] + [CF2 / (1+k)2] + … [TCF / (k-g)] / (1+k)n-1]
You may now get dizzy reading the formula, but here is we define each of those terms.
- CF1: The one year expected cash flow
- CF2: The two years expected cash flow
- TCF: The overall expected cash flow. It is usually also called “terminal cash flow.” You can find it by calculating anything beyond 5 years.
- k: The discount rate or required rate of return
- g: The expected growth rate
- n: The number of years included in the model
The advantages and drawbacks of the discounted cash flow model
The rising of accounting scandals in these recent years has increased the popularity of cash flow metrics as the proper valuation. That is because cash flow is generally more difficult to manipulate in the company earning reports than revenue and profits.
Yet, cash flow can also be misleading. For instance, if a company sells a lot of assets, it can have a positive cash flow. But that company is actually worthless without the assets it sold. This model, moreover, has also one of the most complicated matrices compared to other models.
Besides, you need to also find information on whether that company is currently sitting on huge cash or reinvesting them back.
Similar to other models, this model also can only be accurate once you have accurate cash flow figures.
Also read: Making Profit by Dividend Growth Investing
