The DCF Model

Today, we can easily buy and sell stocks using our smartphones. But if a company's stock is trading at $50 per share, how can we tell whether that price is expensive or cheap? To answer this question, we first need to understand the difference between a stock's price and a company's value. A stock represents a small ownership stake in a company. Buying a stock is therefore not simply a bet that its price will rise. It also means buying a small piece of a business. But how can we determine what that business is worth? To understand this, imagine a small coffee shop. Suppose the coffee shop generates $10,000 in cash each year after paying its operating expenses, taxes, and the investments needed to maintain the business. If the shop can continue generating cash in the future, its owner could receive money from the business year after year. How much would be reasonable to pay for this coffee shop? If you could buy it for $10,000, it might be an attractive opportunity. The shop could potentially generate enough cash to cover its purchase price in just one year. But what if the owner wanted $10 million? Paying that much for a business that generates only $10,000 a year would be difficult to justify. This example shows why a company's ability to generate cash in the future matters when determining its value. One method that uses this idea is called the DCF model. DCF stands for "Discounted Cash Flow." It is a method of estimating a company's value by predicting the cash it will generate in the future, converting that cash into today's value, and adding those amounts together. But why do we need to convert future cash into today's value instead of simply adding it up? Imagine someone offers you a choice between receiving $100 today and receiving $100 one year from now. Which would you choose? Most people would prefer to receive the money today. They could spend it immediately, deposit it in a bank, or invest it to earn additional money. Suppose you could earn a guaranteed annual return of 10% on an investment. In that case, $100 today would become $110 in one year. Looking at the situation in reverse, receiving $110 one year from now would be equivalent to receiving $100 today. The process of converting future money into its value today is called "discounting." The rate used in this calculation is called the "discount rate." With a discount rate of 10%, the present value of $110 received one year from now is $100. However, real businesses cannot guarantee their future earnings. Sales might decline, new competitors might enter the market, or unexpected expenses might arise. For this reason, the discount rate used in a DCF model reflects not only the time value of money but also factors such as business risk and the cost of financing the company. The first step in building a DCF model is estimating how much cash a company will generate in the future. One measure commonly used for this purpose is called "free cash flow," or FCF. Free cash flow is the cash a company generates after accounting for the cash needed to operate and invest in its business. A company might report a large accounting profit while generating relatively little free cash flow if customers have not yet paid their bills or if the company needs to spend heavily on equipment and facilities. For example, imagine a company reports $1 million in profit from selling products. If some customers have not yet paid for those products, or if the company has spent a large amount of money building a new factory, the cash generated by the business may be much smaller than its reported profit. For this reason, the DCF model focuses not simply on revenue or accounting profit, but on how much cash a business can actually generate. Now, consider a hypothetical company. Suppose the company is expected to generate $1 million in free cash flow one year from now, $1.1 million in two years, and $1.2 million in three years. Assume that the appropriate annual discount rate is 10%. The present value of the $1 million received in the first year would be approximately $909,000. The $1.1 million received in the second year would have a present value of approximately $909,000, while the $1.2 million received in the third year would be worth approximately $902,000 today. Each future cash flow is worth less in present-value terms because it has been discounted. Also, when the amounts are the same, cash received further into the future has a lower present value. Adding the present values of these three years of cash flows gives us approximately $2.72 million. Does that mean the company is worth $2.72 million? Not necessarily. Most businesses do not shut down after three years. They may continue generating cash in their fourth, fifth, and later years. A DCF model therefore usually forecasts cash flows for a specific number of years and then estimates the value of the cash flows beyond that forecast period. This additional value is called "terminal value." It represents the value, at the end of the forecast period, of the cash flows a company is expected to generate afterward. Suppose our hypothetical company's free cash flow is expected to grow by 2% annually after the third year. Using that growth rate and a 10% discount rate, we can calculate a terminal value of approximately $15.3 million at the end of year three. Discounting that amount back to today gives us a present value of approximately $11.5 million. If we add this to the approximately $2.72 million from the first three years, we get a total business value of approximately $14.2 million. This example uses a simplified DCF model based on cash flows available to both lenders and shareholders. Therefore, the $14.2 million represents the value of the company's operations, rather than just the portion owned by shareholders. How can we determine the value that belongs to shareholders? We need to consider the company's debt and cash holdings. Suppose the company has $3 million in debt and holds $800,000 in cash. Adding the $800,000 in cash to the approximately $14.2 million business value and subtracting the $3 million in debt gives us an equity value of approximately $12 million. If the company has issued one million shares of stock, we can divide that $12 million by one million shares to estimate a value of approximately $12 per share. This estimated value is called "intrinsic value." Unlike the market price, which is the price at which investors are currently buying and selling shares, intrinsic value is an estimate based on the company's expected future cash flows. What if the stock is currently trading at $9 per share? Since the DCF model estimates its intrinsic value at $12, an investor might conclude that the stock is trading below its estimated value. On the other hand, if the stock is trading at $15, it might appear expensive relative to that estimate. However, there is an important problem with this calculation. Nobody knows exactly how much cash a company will generate in the future. The company might grow faster than expected, but it could also struggle and generate less cash. Using a discount rate of 12% instead of 10% would change the result. Assuming a long-term growth rate of 1% instead of 2% would also produce a different valuation. Terminal value is particularly important because it often accounts for a large portion of a company's estimated value. Even a small change in the assumed long-term growth rate can significantly affect the final result. For this reason, a DCF model is not a machine that reveals the exact price a company should have. It is a tool for estimating value based on assumptions about the future. In practice, investors often calculate several possible valuations rather than relying on a single number. They might consider a scenario in which the company grows faster than expected, one in which it grows as expected, and another in which its business struggles. These different scenarios help investors understand how widely the estimated value might vary. Investors may also consider whether there is a sufficient difference between the estimated intrinsic value and the market price. The idea of buying a stock for less than its estimated value to allow for possible errors is known as a "margin of safety." However, having a margin of safety does not guarantee that an investment will be profitable or prevent losses. Another limitation of the DCF model is that it can be difficult to use for companies whose future cash flows are highly uncertain. A mature business with relatively stable operations may be easier to value than a young company that has not yet become profitable or operates in a rapidly changing industry. Despite these limitations, the DCF model is valuable because it encourages investors to think about a company's actual ability to generate cash rather than focusing only on changes in its stock price. Stock prices change every day as investors react to expectations and market conditions. But a company's long-term ability to generate cash depends on factors such as its competitive position, growth opportunities, and operating costs. Ultimately, the central idea behind the DCF model is to calculate what a company's future cash flows are worth today. The resulting estimate is not guaranteed to be correct, and buying a stock below its estimated intrinsic value does not guarantee a profit. Even so, the DCF model teaches investors to ask an important question. Instead of focusing only on what a stock costs today, it encourages them to consider how much the cash a company will generate in the future is worth today.