A good investor doesn't work off hunches, but uses proper analysis to make sure that they have adjusted for what's to come in the future. One of the methods of analysis is to use a discounted cash flow valuation.
What Is Discounted Cash Flow Valuation?
Discounted Cash Flow (DCF) analysis is a method investors use to determine whether an investment is worthwhile by estimating its future returns adjusted for the time value of money. The time value of money -- the concept that a given sum of money is worth more now than in the future -- discounts projected future free cash flows to arrive at a present value. If the present value is greater than what the investment costs, then the investment is probably a good one.
What Is a Discount Rate?
The discount rate reflects the time value of money and the risk premium, or the additional rate of return investors expect in exchange for taking on risk that they may not receive any cash flow on the investment. The discount rate is also a weighted average cost of capital that reflects the risk of the cash flows -- more on that later.
Discounted cash flow analysis is generally accepted in finance as a good way to determine the value of investments that have predictable cash flows like bonds, real estate or a company. The result is only valid depending on how good you are at correctly estimating your future cash flows, however. For instance, if you expect to receive $2,000 rent for an apartment each month and use that cash flow as an input, it will only be correct if your tenant pays you every month.
The discounted cash flow method adds up the series of future cash flows the investment is expected to produce, then converts them into one number that represents the present-day equivalent value of the cash flow: the present value (PV).
The central idea behind the method is the time value of money. To measure how much more money is worth in the present than in the future, one deducts the opportunity cost to waiting for one's money with a discount rate.
Consider that, in addition to your loss of use if you don't get your hands on it right away, there's also inflation gradually eroding your money's value and purchasing power.
In other words, if you're going to part with your money for any period of time, you probably expect a larger sum in return than you started with -- it's where the concept of interest comes from. Whether you're lending or investing, the goal is to make a gain to compensate you for going without your money for a while.
For example, suppose your friend offers to repay you $2,000 today or $2,050 next year. You would weigh whether you'd earn more than $50 over the next year by investing your money elsewhere before choosing to delay receiving payment for that long. Other factors include your time preference (whether you need the money right now or can wait a while to get it back) and whether you trust your friend to actually repay you -- another reason why money is worth more in the present: it may never materialize in the future. As the saying goes, "a bird in the hand is worth two in the bush."
So if you invest your $2,000 with your friend to gain $50 next year, your future value, or the value your investment will grow to in the future, is $2,050. You're compounding at a 2.5% discount rate.
Likewise, if your friend delays a year in repaying you and only returns the original $2,000, the present value is $1,950 because you didn't earn interest on it. You're discounting at the 2.5% discount rate. That $1,950 present value is the value of the future $2,000 payment today.
So in a DCF calculation, you're taking the expected cashflows of any given investment, then discounting it by the discount rate to find out what it's worth today.
Discounted Cash Flow of Alternative Investments
What if you could have made more than the $50 your friend is offering for the one-year time period by investing your $2,000 in a risk-free investment like U.S. Treasurys? The appropriate discount rate would be the opportunity cost of capital, a key factor in calculating the discounted cash flow. In this case, it is the rate of return for the comparable investment opportunity with a similar risk profile.
Although there's no such thing as a 100% risk-free investment, short-term U.S. Treasurys or other stable developed markets' short sovereign debt are generally seen as having very low risk and are usually the benchmark against which other investment returns are measured, and for a stock or bond investment would serve as a god discount rate.
If you can make more money with a low-risk investment like Treasurys or are willing to take on a little more risk and buy stock in a mature, dividend-paying company with historically stable earnings and free cash flow and low risk of non-payment, that increases the discount rate in that equation. The larger the discount rate is, the bigger the reduction from future value to present value.
For instance, if you are able to make 3% in a short-term treasury, your present value would be $1940 because the opportunity cost is greater.
If you're looking at stock in a stable, reputable company, the discount rate is higher because they pay a small premium over the safest investments -- Treasurys. The additional charge over a risk-free rate investors expect to receive for taking on additional risk is called a risk premium. The greater the risk, the larger the discount rate.
Discounted Cash Flow Valuation for Stocks
As mentioned, discounted cash flow analysis is better as a way to determine the value of investments that have predictable cash flows like bonds, real estate and asset leasing. For stocks, however, DCF presents what Curtis Jensen, former Third Avenue Management chief investment officer, called the "Hubble Telescope problem." Jensen reportedly said that in equity investing, DCF is like the Hubble Telescope because if you turn it a fraction of an inch you're in a different galaxy. Even the tiniest changes to growth estimates, growth rates and cost of capital will produce extremely different results.
Another issue with using DCF for valuing stock investments, aside from wide swings in results depending on the investor's assumptions, is that investors often buy stocks because they believe in the company CEO and her vision, or the company's "story," and there's no room for a story in a DCF valuation analysis. Although a company's cash flows are important, they can be difficult to predict in large companies where they can be varied and complex. And in short term periods of flux, such as when a corporation is investing in its own growth, cash flow projections may not accurately reflect the stock's valuation for the long term.
Still, DCF is considered one of the most valuable tools for measuring a company's performance and future worth. It can reveal truths that P/E ratios and a company's reported revenue and earnings don't convey as clearly.
The DCF calculates a company's intrinsic value based on cash flow projections which are likely to change in time, but the company isn't as likely to try to distort cash flows the way it may do with earnings, which are more closely watched by shareholders.
Although the DCF valuation is the best metric for long-term investors, it's based on assumptions that may change suddenly due to macroeconomic conditions and are difficult to predict for longer than a five- to 10-year period.