1) What is Discounted cash flow ?
Discounted cash flow is a valuation method that calculates the value of an investment based on the present value of its future income. The method helps to evaluate the attractiveness of an investment opportunity based on its projected future cash flows.
2) Where you can use Discounted Cash flow analysis ?
DCF model can be used for valuation of a project, company, stock, bond or any income producing asset.
The DCF method can be used for the companies which have positive Free cash flows and these FCFF can be reasonably forecasted. So, it cannot be used for new and small companies or industries which have greater exposure to seasonal or economic cycles.
3) How to Use the Discounted Cash Flow Model to Value Stock ?
- Step 1 :- Calculate the Free Cash flow to the firm
- Step 2 :- Project the future FCFF –You need to project the future FCFF for the next couple of years. You can analyze the historical data to understand the past FCFF growth trend. However, relying on historical data only won’t give you the right result, so consider the present financials as well as future potential of the company while projecting the growth rate.
- Step 3 :- Discount the FCFF :- Calculate the present value of this cash flow by adjusting it with the discount rate. Discount rate is your expected return %.
- Step 4 :- Calculate the Terminal Value :- It is the value of the business projected beyond the forecasting period. It is calculated by assuming the constant growth of a company beyond a certain period known as terminal rate.
- Step 5 :- Add discounted FCFF with Terminal value and adjust the total cash and debt.
- Step 6 :- Divide the Figure calculated in Step 5 by the outstanding number of shares to find out the DCF Value.
- Step 7 :- Adjust the MOS to find out the Fair value. Margin of Safety provides discount for uncertainties in the business.
You can use our DCF calculator directly to determine the Fair Value.
4) What is FCFF (Free cash flow to the firm) ?
FCFF means the amount of surplus cash flow available to a business after a it pays its operational expenses like inventory, rent, salaries etc. and also invests in fixed assets like plant and machinery, property etc.
Free cash flow is important metric as it tells about the company’s ability to deploy capital in future projects. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. Also, as cash is difficult to manipulate compared to other variables, FCFF is more reliable indicator of a company’s performance than net earnings.