Discounted Cash Flow Analysis
A discounted cash flow (DCF) analysis is a valuation method based on the notion that the value of a company (and its stock price) can be calculated from its projected free cash flows. The DCF method should only be used for companies that have predictable positive future cash flows.
The value given to a company as a result of the DCF is an intrinsic value. In a DCF analysis, the forecasted free cash flows are discounted to their present value and summed up to yield a valuation of the business. Assuming the company has no debt, this business valuation can be divided by the number of outstanding shares to yield an intrinsic value of the stock.
If the company does have debt, simply subtract the amount of cash the company has from the amount of debt to arrive at net debt. Then subtract net debt from the company’s valuation to find the value of the business’s equity. Then take this number and divide by the number of shares to arrive at a per share value.
Because the DCF is based on forecasted cash flows and forecasted growth rates, the accuracy of the model is dependent on the accuracy of these predictions.
In a very simple DCF analysis, in which we expect free cash flows to grow at a stable rate, we can apply a present value perpetuity model to arrive at the value of the business. The following is called the Gordon growth model:
Example: HOT-TOTS, a baby apparel company, has revenue of