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But what is the present value<\/em> of all the future cash flows of a business? How do you even calculate this? This is where the discounted cash flow model<\/strong> comes in, a popular valuation technique used by investors and the topic of today\u2019s article. <\/p>\n\n\n\n In this post, we are going to learn: <\/p>\n\n\n\n <\/p>\n\n\n\n A discounted cash flow model is just that: an estimate of the future cash flow a business will generate while discounting every year back to the present day<\/strong>. <\/p>\n\n\n\n Advanced investors may build discounted cash flows (DCFs) with dozens or even a hundred variables. These models can be math-intensive, discouraging people from trying to learn the techniques. We don\u2019t want to overwhelm investors just learning about a DCF, as it is a useful tool that anyone can use to improve their stock-picking skills. So, let\u2019s keep things simple. <\/p>\n\n\n\n Luckily, these complicated models are not necessary to build a discounted cash flow model (in fact, they may be counterproductive, but that\u2019s a topic for another post). At the end of the day, you need a few variables: <\/p>\n\n\n\n <\/p>\n\n\n\n That\u2019s it. If you have these four variables, you can calculate a DCF for any company. <\/p>\n\n\n\n Let\u2019s review a basic example to see how it works with Microsoft<\/strong>. For our variables, let\u2019s assume: <\/p>\n\n\n\n Side note: most investors will include a terminal growth rate<\/em> that runs in perpetuity in their calculations to value a stock more precisely. Today, we will stick with a 10-year time frame so you can first learn the basics, as terminal rates add in some complications. For anyone interested in learning about terminal growth and terminal value, check out our article<\/a> on the topic. <\/em><\/strong> <\/p>\n\n\n\n To calculate this hypothetical DCF for Microsoft, you first apply a 10% compound growth rate to $100 for 10 years. That means you get $110 in cash flow in year one, $121 in year two, and so on (values included in column one below). Or, in Excel, multiply the next row by 1.1. <\/p>\n\n\n\n Then, for each year, you need to apply a 5% compounded discount rate, giving you a multiplier for each year’s nominal cash flow value that discounts<\/em> the value back to today\u2019s dollars. To do so, you take the number 1 and divide it by 1.05, compounding for each successive year. So for year one, you get a multiplier of 0.9524, then 0.9070 in year 2, and on it goes (values in column two below). <\/p>\n\n\n\n Finally, you multiply the nominal cash flow value from each year by its discount multiplier to get the present value of each year\u2019s cash flow. In the table below, column one is multiplied by column two, with the output in column three. You add the values together to get the total present value of these 10 years of cash flow. <\/p>\n\n\n\n There you have it, a basic discounted cash flow model. <\/p>\n\n\n\n Luckily, today, we don\u2019t have to perform these ten calculations by hand. Numerous websites such as this one will perform DCFs for you at the click of a button. You can also build custom DCF calculators in Microsoft Excel or Google Sheets to suit your needs. <\/p>\n\n\n\n After inputting our four variables from above, we get a present value of approximately $1,303 for our hypothetical Microsoft company (in reality, Microsoft generates billions of dollars in cash flow each year). <\/p>\n\n\n\n Of course, Microsoft will likely operate for longer<\/em> than 10 years into the future. Still, this DCF is telling us our estimate for the present value of Microsoft\u2019s cash flows over the next 10 years using our growth and discount assumptions. <\/p>\n\n\n\n The final step is to evaluate your estimate of intrinsic value on a per-share basis, which tells you your own estimate of the value of the stock today. In our above example, Microsoft has a present value of approximately $1,303. If the company has 100 shares outstanding, then the present value of each share is $1,303 divided by 100, or $13.03 per share. <\/p>\n\n\n A DCF estimates \u2013 according to your own assumptions \u2013 the value of a stock.<\/p>\n\n\n\n If you are still confused, try calculating a DCF using different variables. Or try it with a real company such as Apple or Amazon using their financials. It takes practice to understand the ins and outs of the DCF model fully; you won\u2019t perfect it in a day. <\/p>\n\n\n\n <\/p>\n\n\n\n While building your first DCF might take time, it is easy to use its output to value a stock. If, on a per-share basis, your DCF spits out a value close to the business’s current stock price, it is fairly valued<\/em>. If it is significantly above, the stock may be undervalued. If it is below, the stock may be overvalued<\/em>. <\/p>\n\n\n\n Let\u2019s repeat this for clarity, as it is vital for informing an investor. If the per-share present value estimate from your DCF is: <\/p>\n\n\n\n Of course, investing in the real world has more nuance and uncertainty. This brings us to focus on the discount rate, your most important decision when building a basic discounted cash flow model. <\/p>\n\n\n\n <\/p>\n\n\n\n The discount rate is the most opaque variable in the DCF, but it can greatly affect the present value the model spits out. <\/p>\n\n\n\n But what even is the discount rate? Its name is a bit misleading. While it technically is discounting<\/em> the cash flow from each future year estimate, the discount rate is essentially your forward return estimate for the stock. The higher the discount rate, the lower your present value will be. Inverting this equation, the lower your per-share present value, the higher your forward returns will be, all else equal. <\/p>\n\n\n <\/p>\n\n\n\n Of course, the actual stock may be trading at a wildly different spot than your present value estimate, which we discussed in the above section, and should inform your buy, sell, or hold decision. <\/p>\n\n\n\n Changing the discount rate can significantly change the output of your DCF model. If we change the discount rate of our above Microsoft scenario to 10%, the per-share present value is $10 for the next 10 years. That is only 77% of the $13.03 per share value we got using a 5% discount rate. If we change the discount rate to 15%, the per-share value is just $7.89. <\/p>\n\n\n\n Investors will use wildly different discount rates depending on their risk tolerance. Some use the interest rate on 10-year U.S. treasury bonds (currently 4.2%, for reference), others use the long-run returns from the U.S. stock market of ~10%, while others may go even further to 15% or 20%. There is no right answer; it is up to every investor to decide for themselves. <\/p>\n\n\n\n <\/p>\n\n\n\n Discounted cash flow models can be helpful, but they are inherently flawed. Why? Because they try to predict an unpredictable future precisely. <\/p>\n\n\n\n In our Microsoft example, we said its free cash flow would grow by 10% each year. Who’s to say it won\u2019t grow by 5%? 15%? Or not even grow at all? We can use historical data, management guidance, and our understanding of Microsoft\u2019s business to predict future cash flow. But to estimate its cash flow 10 years into the future down to the decimal point? That is an exercise in false precision. <\/p>\n\n\n <\/p>\n\n\n\n The stock market is a dynamic arena of competitive groups (i.e. businesses) trying to win the allocation of dollars in our global economy. Given the multi-variate nature of our global economy, there are very few of these businesses \u2013 if any \u2013 where you can precisely predict their future cash flow. <\/p>\n\n\n\n Some investors may never explicitly build DCF models. In fact, legendary investor Warren Buffett says he has never actually made one. But he is still estimating the future cash flows of a business and weighing that estimate vs. the price he can pay for the stock at today\u2019s price. He just might be doing it in his head. <\/p>\n\n\n\n At the end of the day, you don\u2019t have to build a complex DCF model for every stock you look at. What\u2019s important is that you understand that stock returns for buy-and-hold investors come from the cash flow a company generates for shareholders. In fact, I might argue it is the most important thing you will ever learn as an investor. <\/strong> <\/p>\n\n\n\n Brett Schafer is an investor, host of the Chit Chat Stocks Podcast<\/a>, and writer at the Motley Fool<\/a>.<\/p>\n\n\n\n\n
How to Build a Simple Discounted Cash Flow Model <\/strong><\/h2>\n\n\n\n
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<\/figure><\/div>\n\n\nExample: Microsoft<\/h3>\n\n\n\n
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Year<\/td> Cash Flow<\/strong><\/td> Discount Rate<\/strong><\/td> Present Value<\/strong><\/td><\/tr> 1<\/td> $110<\/td> 0.9524<\/td> $104.76<\/td><\/tr> 2<\/td> $121<\/td> 0.9070<\/td> $109.75<\/td><\/tr> 3<\/td> $133.1<\/td> 0.8638<\/td> $114.97<\/td><\/tr> 4<\/td> $146.41<\/td> 0.8227<\/td> $120.45<\/td><\/tr> 5<\/td> $161.05<\/td> 0.7835<\/td> $126.18<\/td><\/tr> 6<\/td> $177.16<\/td> 0.7462<\/td> $132.19<\/td><\/tr> 7<\/td> $194.87<\/td> 0.7107<\/td> $138.50<\/td><\/tr> 8<\/td> $214.36<\/td> 0.6769<\/td> $145.10<\/td><\/tr> 9<\/td> $235.79<\/td> 0.6447<\/td> $152.02<\/td><\/tr> 10<\/td> $259.37<\/td> 0.6140<\/td> $159.26<\/td><\/tr> <\/td> <\/td> Total:<\/strong><\/td> $1,303.18<\/strong><\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n ![\"Equation](\"https:\/\/eor7ztmv4pb.exactdn.com\/wp-content\/uploads\/2024\/02\/Per-Share-Present-Value-1024x576.jpg?strip=all&lossy=1&ssl=1\")
<\/figure><\/div>\n\n\nHow to Use a DCF to Value a Stock<\/strong><\/h2>\n\n\n\n
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The Importance of the Discount Rate and What it Tells Investors <\/strong><\/h2>\n\n\n\n
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<\/figure><\/div>\n\n\nThe Limitations of DCF Models <\/strong><\/h2>\n\n\n\n
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<\/figure>\n<\/div>\n\n\n\nBrett Schafer<\/h2>\n\n\n\n