Basic DCF Explained
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Basic Company Discounted Cash Flow (DCF) Valuation
The value of a company is the present value of its future cash flows, that's about it. If you have the choice between getting a dollar from me now and getting a dollar from me a year from now, which would you pick? You'd pick the dollar now because you know it's worth more than the dollar a year from now. Why is it worth more? It's worth more for a number of reasons:
Utility: you can use the dollar now instead of having to wait.
Inflation: At 3% inflation a dollar will be worth just 97 cents a year from now.
Risk: Maybe I won't be around in a year from now.
So you have to decide then at what price would you not care whether you got the dollar now or a year from now. Inflation we already covered. You shouldn't care whether you get $1.00 now or $1.03 a year from now if we consider inflation. But what about utility and risk? You don't know who the heck I am and maybe you really need money now. Maybe if you combine these two things on top of inflation you'd say I have to promise to give you $1.50 a year from now to equal $1.00 today.
It's the same thing with companies. A company is just a little money-making machine that churns out cash flows. It will be churning out cash flows now and into the future. You just don't know exactly how much and for how long. And that's why you buy with a margin of safety.
Take Johnson & Johnson (NYSE: JNJ) as an example. Here's a nice big stable company growing revenues at around 4% a year. So say if JNJ earned $4.00 per share now, you'd get $4.00 this year, $4.16 next year, and a $4.33 next year. The value of all of those cash flows over the next three years is $12.49.
BUT...some of those cash flows come later than others. We should discount those later cash flows by some rate. What should we pick? Well, it should be at least 3-4% to take into account inflation, but it should probably be even larger since this is a company, and even a stable company like JNJ hits bumps in the road. How about we discount those cash flows by 10%, or about the minimum rate of return we'd want from this investment? Then we'd have: $4.00 + $4.16/1.1^1 + $4.33/1.1^2 = $11.36. That's a bit cheaper than $12.49, as it should be.
While this little experiment was run on JNJ's earnings per share over the next three years to make things easy, when we value the company for real we want to look at the money it has a good chance of earning much further out than just three years from now, and to also run the valuation with a free cash flow estimate, not an earnings per share estimate. Free cash flow is the actual cash money you have left over after running the business and reinvesting what you need to grow the business. Earnings per share has a lot of accrual accounting non-cash gotchas in there and also doesn't factor in money spent on capex.
Formulas are a lot less important than the big idea concepts of basic valuation. If you type in "DCF calculator" in a search engine, you will get a bunch of hits where you plug in a bunch of numbers you glean from the financial reports. But you won't know what is going on behind the scenes or even if you agree with the basic concepts the calculator was built on (and in that sense, you will be just like the people at Moody's and S&P who valued those securitized mortgages). Worst case is where I see people plug inaccurate numbers from Yahoo Finance into an online DCF calculator they don't understand and come out feeling secure in the number that got spit out.
Here's a few websites I recommend that go into more of the basics of valuation, including a great website that takes you through the basics of creating your own Excel DCF calculator step-by-step:
http://www.investopedia.com/university/fundamentalanalysis/
http://www.investopedia.com/university/dcf/
http://www.xdiv.com/invest/dcf_tutorial/
Mike Sandrik owns shares of JNJ.
