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Using Discounted Cash Flow (DCF) Analysis to Value Companies and Stocks

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In this article, you will learn:

Lesson 4: Using Discounted Cash Flow (DCF) Analysis to Value Stocks

What is "Discounting"?

The idea of discounting is a little confusing at first but actually very intuitive once you get the hang of it. This lesson is also the most difficult of the five WeathLift stock investing lessons to understand, so don't feel intimidated if you need to go over it a few times before you're comfortable with the ideas in this lesson.

Discounting is simply the idea that $1 given to you today is worth more than $1 promised to you in the future. The longer the time period until the promised $1 is paid, the less that promise is worth today. Again, the concept itself is simply common sense -- if I offered you $1000 now versus $1000 a year from now, obviously you would prefer the first option and value it more. Being promised $1000 in a year's time means you can't interest on the money in the meantime, and also means that there is an uncertainty in whether or not you'll actually get the money. Importantly, the promise of $1000 a year from now is worth less than $1000 today. It has a present value of less than $1000.

This concept can be applied in more exact ways using a discount rate. A discount rate is a kind of interest rate which you demand on money promised in the future, because of the very fact that it is only a promise in the future and not an actual payment today. It is calculated as the sum of risk-free interest rate that you could have gotten on your money if you had received it today (which is usually taken as the interest rate on essentially risk-free government Treasury bills) and a risk premium for the uncertainty that the promise will actually be fulfilled and you will get the expected amount after the time period. The risk premium varies depending on the perceived riskiness of the specific stock, but is usually around 6% for safer large caps and up to 9% for riskier small caps.

Discount Rate = Risk-Free Interest Rate on Treasuries + Risk Premium

For example, if the current interest rate on Treasury bills is 4% and we take the risk premium as 7%, we get a discount rate of 11% per year. Once we have the discount rate, we can simply divide any amount of money in the future by this rate raised to the power of the number of years until we receive the money to get the present value of the payment.

Present Value = Payment in Future ÷ (1 + Discount Rate) No. of Years Until Payment

For example, if I am promised $1000 in 5 years and I put a discount rate of 11% on this promise, the present value of that $1000 is:

$1000 ÷ (1.11)5 = $593.45

As we expect from discounting, the present value of $593.45 is less than the promised future value of $1000. A promise of $1000 in 5 years time means I miss out on getting interest on that $1000 in the meantime, and also that I take on the risk of not actually receiving the money when payment is due. Therefore, I only value the payment at $593.45 today. $593.45 is the present value of the payment, and $593.45 is the most I should be willing to pay to receive this $1000 payment in 5 years time.

How do I use discounting to find undervalued stocks?

The simple examples discussed earlier may seem irrelevant to stock investing, but by buying a stock, you are essentially being promised a number of regular future payments in the form of earnings by the company. The stock price today can therefore be just thought of as a sum of all the present values of all future payments, because the sum of the present values of future company earnings is the most you should be willing to pay for a stock.

Using discounting of future earnings to price a stock is known as discounted cash flow (DCF) analysis. To price a stock using expected future earnings, you would need to discount every dollar of future earnings and add them all together to get the stock price. Doing this is difficult and requires complex annuities formulas which can be hard to work with. Instead, you can simply use the WealthLift Discounted Cash Flow (DCF) calculator below to determine a stock price based on your own earnings estimates:

WealthLift DCF Stock Valuation Calculator:

Current Earnings-Per-Share (EPS): $

This EPS will grow at: % for the next: years.

After that time, EPS will grow at %

Discount Rate: %

To use the calculator:

  1. Enter the current Earnings-Per-Share (EPS) of the company. You can look this number up for any company by typing the company's stock symbol on the WealthLift Stock Research page and looking at financial summary.
  2. Enter the percentage growth in profits you expect in the next few years for the company, and the number of years you think the company will maintain this rate of growth. This will be based on your analysis of the company's products and the profits they can generate from these products.
  3. Enter the percentage growth in profits you expect from the company in the long run, after the initial growth period. This number should be conservative (less than 5%) because no company can grow at a high rate forever.
  4. Enter the discount rate you'd like to use. If you don't know what to put here, 11% is a good start. This should be higher (12-13%) for riskier stocks, such as small caps, and lower (9-10%) for less risky stocks, such as blue chips.
  5. Click 'Calculate Fair Stock Price' to get a fair stock price valuation for the company based on your estimates. If this number is significantly higher than the current stock price, you may have discovered a Buy opportunity.

For example, based on a quick search through the WealthLift Stock Research page, we can see that Apple Inc. (AAPL) had earnings per share (EPS) of $20.992 in the past year. Let's say that we estimate earnings to grow at a fairly high rate for a large cap of 10% a year for the next 5 years based on some of the new Apple products coming out soon, but only at 3% a year after that due the company maturing and the product sales only growing at this slower rate. We choose a discount rate of 11%, as this is a solvent, large company with good brand loyalty, and therefore, reasonable risk. Putting these values into the calculator, we get a DCF valuation of $360.44. Since this is higher than the current stock price for Apple (as of June 15, 2011), we may have found an undervalued stock based on our earnings estimates and could choose to invest in this stock.

What is a margin of safety?

Benjamin Graham was a highly influential 20th Century American economist and professional investor who taught at Columbia Business School and authored two of the most influential books on investing ever written, "Security Analysis" and "The Intelligent Investor". While teaching at Columbia, Graham taught a young student named Warren Buffett, who became the first and only student in any of Graham's classes to earn an A+. Buffett, who obviously went on to be one of the most successful investors of all time, would later claim Graham as his single greatest influence and also described Graham's book "The Intelligent Investor" as "the best book about investing ever written."

One of Graham's greatest contributions to the world of investing was the concept of a "margin of safety". Graham noted that no one could accurately predict the future and that any estimate of future profitability of a company was at best an educated guess. He therefore realized the need to include a margin of safety in the valuations of companies, so that even if the estimates were significantly off, you could still come out ahead by having a large margin of safety to work with.

Margin of Safety = (Your Fair Stock Price Valuation – Current Stock Price) ÷ Current Stock Price x 100

For example, if using DCF analysis you come with a fair value stock price of $50, while the current market stock price is $40, you have a 25% margin of safety between the actual stock price and what you believe to be the fair value for the stock. For Graham, any margin of safety of less than 40-60% was considered too risky and unprofitable. Therefore, to be a successful investor, it is important to adopt this idea of a margin of safety early on and to invest only in ideas where the stock has a built in margin of safety between your purchase price and what you believe the stock is worth.