How do I perform a discounted cash flow valuation?

Basic Company Discounted Cash Flow (DCF) Valuation

The value of a company is the present value of its future cash flows … and that’s about it.

If you have the choice between getting a dollar from me now and getting a dollar from me a year from now, which would you pick? You’d pick the dollar now because you know it’s worth more than the dollar a year from now. Why? A few reasons:

Utility: You can use the dollar now instead of having to wait.

Inflation: At 3% inflation, a dollar will be worth just 97 cents a year from now.

Risk: Maybe I won’t be around in a year from now.

So, you have to decide then at what price would you not care whether you got the dollar now or a year from now. Inflation we already covered. You shouldn’t care whether you get $1.00 now or $1.03 a year from now if we consider inflation.

But what about utility and risk? You don’t know who the heck I am and maybe you really need money now. Maybe if you combine these two things on top of inflation, I’d have to promise to give you $1.50 a year from now to equal $1.00 today.

Discounted cash flow and companies

It’s the same thing with companies. A company is just a money-making machine that churns out cash flows, now and into the future. You just don’t know exactly how much and for how long. And that’s why you buy with a margin of safety.

Take Johnson & Johnson (NYSE: JNJ) as an example. Here’s a big, stable company growing revenues at around 4% a year. So if JNJ earned $4.00 per share now, you’d get $4.00 this year, $4.16 next year, and a $4.33 next year. The value of all of those cash flows over the next three years is $12.49.

BUT … some of those cash flows come later than others. We should discount those later cash flows by some rate. What should we pick? Well, it should be at least 3%-4% to take into account inflation, but it should probably be even larger since even a stable company hits bumps in the road.

How about we discount those cash flows by 10%, or about the rate of return we’d expect from the broad market? Then we’d have: $4.00 + $4.16/1.1^1 + $4.33/1.1^2 = $11.36. That’s a bit cheaper than $12.49, as it should be.

More to consider with the DCF

While this little experiment was run on JNJ’s earnings per share over the next three years to make things easy, when we value the company for real, we want to look at the money it has a good chance of earning much further down the road, and also to run the valuation with a free cash flow estimate, not an earnings per share estimate.

Free cash flow is the actual cash money you have left over after running the business and reinvesting what you need to grow the business. Earnings per share has a lot of accrual accounting non-cash gotchas in there, and also doesn’t factor in money spent on capital expenditures.

Not just a DCF formula

Formulas are a lot less important than the big-idea concepts of basic valuation.

If you type in “DCF calculator” in a search engine, you’ll get a ton of hits where you plug in a bunch of numbers you glean from the financial reports, but you won’t know what is going on behind the scenes … or even if you agree with the basic concepts the calculator was built on.

The worst case is when people plug inaccurate numbers into an online DCF calculator they don’t understand and come out feeling secure in the number that got spit out.

Here are a few websites I recommend that go into more of the basics of valuation, including a great website that helps you create your own Excel DCF calculator step-by-step:

http://www.investopedia.com/university/fundamentalanalysis/

http://www.investopedia.com/university/dcf/

http://www.xdiv.com/invest/dcf_tutorial/

And if you want to be aware of the potential pitfalls and shortcomings of the calculations (and you should), here’s a great Fool.com article on why DCF valuations fail.

– Answer provided by Motley Fool member Michael Sandrik

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