How to Use Discounted Cash Flow (DCF) Analysis to Determine Intrinsic Value
Determining the intrinsic value of a stock is crucial for making informed investment decisions. One of the most reliable methods for estimating a stock’s intrinsic value is through
Discounted Cash Flow (DCF) analysis. This technique involves forecasting a company’s future cash flows and discounting them back to their present value, helping investors assess whether a stock is undervalued or overvalued.
In this comprehensive guide, we’ll walk you through the step-by-step process of using DCF analysis to determine a stock’s intrinsic value. We’ll also introduce you to our
Intrinsic Value Calculator, which simplifies this process, making it accessible to both novice and experienced investors.
What is Discounted Cash Flow (DCF) Analysis?
Discounted Cash Flow (DCF) analysis is a valuation method used to estimate the value of an investment based on its expected future cash flows. The core idea is that a company is worth the sum of all its future cash flows, discounted back to their present value. This accounts for the time value of money—the concept that a dollar today is worth more than a dollar in the future.
The key components of DCF analysis include:
- Projected Revenue Per Share: Estimating future revenue growth on a per-share basis over a specified period.
- Net Profit Margin: The percentage of revenue that translates into net profit.
- Cash Conversion Ratio: The proportion of net profit that is converted into free cash flow (FCF).
- Terminal Value: The value of the company’s cash flows beyond the forecast period, calculated using a terminal value method.
- Discount Rate: The desired rate of return, akin to the cost of equity, used to discount future cash flows back to their present value.
Step-by-Step Guide to Performing DCF Analysis
Step 1: Project Revenue Growth Per Share
Begin by estimating the company’s future
Revenue Per Share over the next 10 years. Analyze historical growth rates, industry trends, and company-specific factors to make an informed projection. Our
Intrinsic Value Calculator allows you to input your estimated revenue growth rate per share, streamlining this process.
Step 2: Estimate Net Profit Margin
The net profit margin represents the percentage of revenue that remains as net profit after all expenses are deducted. Estimate this margin based on historical data and industry benchmarks. Inputting this into the calculator helps project future net profits per share.
Step 3: Determine Cash Conversion Ratio
The cash conversion ratio indicates the proportion of net profit that is converted into free cash flow (FCF). It accounts for factors like capital expenditures and changes in working capital. A ratio less than one suggests that not all profits are converted into cash. Our calculator incorporates the cash conversion ratio to provide a more accurate estimation of free cash flow per share.
Step 4: Calculate Free Cash Flow Per Share for Each Year
Using the projected Revenue Per Share, Net Profit Margin, and Cash Conversion Ratio, calculate the Free Cash Flow Per Share for each of the 10 forecasted years:
Free Cash Flow Per Share = Revenue Per Share × Net Profit Margin × Cash Conversion Ratio
Step 5: Estimate the Terminal Value
The terminal value accounts for the value of the company’s cash flows beyond the 10-year forecast period. One common method is using the Terminal Value P/E ratio:
Terminal Value Per Share = Final Year’s Net Profit Per Share × Terminal P/E Ratio
Input your expected Terminal Value P/E ratio into the calculator to compute this value.
Step 6: Determine the Discount Rate (Desired Rate of Return)
The discount rate is your desired rate of return, reflecting the opportunity cost of investing your capital elsewhere. It is akin to the cost of equity. A higher discount rate implies greater risk and a higher required return. Our calculator allows you to set your preferred discount rate.
Step 7: Discount Future Cash Flows to Present Value
Each projected Free Cash Flow Per Share and the Terminal Value Per Share must be discounted back to their present values using the discount rate. The formula for discounting is:
Present Value = Future Cash Flow Per Share / (1 + Discount Rate)n
Where
n is the year number.
Step 8: Sum the Present Values to Determine Intrinsic Value Per Share
Add up all the discounted Free Cash Flows Per Share and the discounted Terminal Value Per Share to get the total intrinsic value per share of the company.
Step 9: Compare Intrinsic Value Per Share to Current Market Price
Compare the calculated intrinsic value per share to the current market price per share. If the intrinsic value is higher than the market price, the stock may be undervalued, presenting a potential investment opportunity.
Step 10: Calculate the Forecast Internal Rate of Return (IRR)
The Forecast IRR represents the expected annualized return of the investment over the 10-year period, considering both the cash flows and the terminal value. Our calculator computes the Forecast IRR, helping you assess whether the investment meets your desired rate of return.
Step 11: Analyze Implied Growth Rates
The calculator also computes the implied Earnings Per Share (EPS) growth rate and the implied Free Cash Flow Per Share growth rate over the forecast period. These are compared to the company’s historical growth rates, providing insight into the reasonableness of your assumptions.
This comparison is displayed in a chart within the calculator, aiding in visualizing how the projected growth aligns with past performance.
Using Our Intrinsic Value Calculator to Simplify the Process
Performing a DCF analysis manually can be complex and time-consuming. Our
Intrinsic Value Calculator simplifies this process by automating calculations and providing a user-friendly interface. Here’s how it helps:
- Input Fields: Easily enter your assumptions for revenue growth per share, net profit margin, cash conversion ratio, terminal value P/E, and discount rate.
- Automated Calculations: The calculator computes projected Free Cash Flows Per Share, terminal value, and discounts them to present value.
- Forecast IRR Calculation: It calculates the expected internal rate of return over the forecast period.
- Implied Growth Rate Analysis: The calculator displays the implied EPS and FCF per share growth rates relative to historical growth rates, assisting in validating your assumptions.
- Adjustable Parameters: Experiment with different scenarios by adjusting input variables to see how they impact the intrinsic value and forecast IRR.
Why the Desired Rate of Return is Used as the Discount Rate
In DCF analysis, the discount rate reflects the riskiness of the investment and the opportunity cost of capital. By using your desired rate of return, which is akin to the cost of equity, you ensure that the intrinsic value calculation aligns with your personal investment goals and risk tolerance. This approach personalizes the valuation process, making it more relevant to individual investors.
External References
For further reading on DCF analysis and intrinsic value, consider these authoritative sources:
Conclusion
Discounted Cash Flow analysis is a powerful tool for determining the intrinsic value of a stock. By following the steps outlined in this guide, you can make more informed investment decisions and identify opportunities that align with your financial goals.
Our
Intrinsic Value Calculator streamlines the DCF analysis process, making it accessible and efficient. By inputting key assumptions, you can quickly estimate a stock’s intrinsic value, forecast IRR, and analyze implied growth rates.
Start using the
Intrinsic Value Calculator today to enhance your investment strategy and make more informed decisions.
