11.3 Discounted Cash Flow (DCF) Model

The Discounted Cash Flow (DCF) model is a powerful tool for estimating a stock's intrinsic value. It considers all expected future cash flows, making it versatile for various companies, especially those with irregular dividends or high growth potential.

DCF analysis involves forecasting future free cash flows, determining a discount rate, and calculating present values. While comprehensive, it's sensitive to input assumptions. Investors should use DCF alongside other valuation methods for a well-rounded analysis.

Discounted Cash Flow (DCF) Model and Stock Valuation

DCF vs dividend discount models

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• DCF model estimates intrinsic stock value based on present value of expected future free cash flows (dividends and share repurchases)
  • Suitable for companies with irregular or no dividend payments (growth stocks)
• Dividend discount models (DDMs) estimate intrinsic stock value based on present value of expected future dividend payments only
  • More appropriate for companies with stable and predictable dividend payments (income stocks)
• DCF model uses free cash flows, while DDMs use only dividend payments
• DCF model is more versatile and can be applied to a wider range of companies, while DDMs are more suitable for companies with consistent dividend policies

Intrinsic value calculation with DCF

1. Estimate the company's future free cash flows (FCFs) over a specific forecast period
   • FCF = Operating cash flow - Capital expenditures
   • Develop detailed cash flow projections for the forecast period
2. Determine the appropriate discount rate, typically the weighted average cost of capital (WACC)
   • Consider the risk-free rate when calculating WACC
3. Calculate the present value of the forecasted FCFs using the discount rate
   • Present value of FCF = $\frac{FCF_t}{(1+WACC)^t}$, where $t$ is the time period
4. Estimate the terminal value at the end of the forecast period
   • Terminal value = $\frac{FCF_{t+1}}{WACC - g}$, where $g$ is the expected long-term growth rate
   • The perpetuity growth rate (g) is crucial for determining the terminal value
5. Discount the terminal value to its present value using the WACC
6. Sum the present values of the forecasted FCFs and the terminal value to obtain the intrinsic value of the stock

• Terminal value represents the value of the company's cash flows beyond the explicit forecast period and often accounts for a significant portion of the stock's intrinsic value

Strengths and limitations of DCF

• Strengths
  • Comprehensive considers all expected future cash flows available to shareholders
  • Flexible can be adapted to various scenarios and assumptions (sensitivity analysis)
  • Fundamental approach focuses on the underlying cash generation capability of the company
• Limitations
  • Sensitive to inputs small changes in assumptions (discount rate, growth rate) can significantly impact the intrinsic value estimate
  • Difficult to forecast accurately predicting future cash flows can be challenging, especially over longer time horizons
  • Ignores market sentiment does not account for short-term market fluctuations and investor sentiment
  • Time-consuming requires detailed analysis and assumptions for each company
• Use the DCF model as one of many tools in a comprehensive investment analysis
  • Compare DCF results with other valuation methods (relative valuation using valuation multiples) and market prices
  • Regularly update assumptions and monitor the company's performance against projections