Before buying a stock you should find out whether its market price is undervalued. You can complete this task with discounted cash flow valuation method.

If you intend to buy stocks on the capital markets, your first step would be to find those which are undervalued in relation to the current market price. This is the only way to be successful and profitable on the long-term. It makes sense to look for cheap stocks, doesnt it? I mean, why would someone be interested in buying expensive stocks? When using terms cheap and expensive I am not speaking in absolute numbers, but rather relative, comparing stock market price with the fair value of the company.

If stock markets would be perfect, all market actors would possess all crucial information about the company and would evaluate the information in the proper manner. But this obviously isnt the case. Nobody really knows what will the iPhone 5 present in the total incomes of the Apple Inc.- plans are one thing, the reality is another. This brings us to the fact that stocks rarely trade at the fair price on the stock markets; they mostly trade above (overvalued) or under (undervalued) the fair value. Overvalued stocks are opportunity to sell; undervalued stocks are opportunity to buy.

Stock analysis is a rather a subjective topic and to become a great analytic, you need a lot of experience and be aware of different methods of valuing the companies. One simple way of calculating fair company value is by comparing the company with key players in the same sector or industry. A more advanced approach is to use discounted cash flow valuation method. Both approaches have some pros and cons. We will focus on the latest method in this article next.

Discounted Cash Flow Valuation Calculation

An abbreviation for discounted cash flow valuation is DCF. Its main principle is to predict how much money the company will generate for investors in the future and discount all the future cash flows on the current date to get its intrinsic value. DCF valuation can be processed in the following steps.

Forecasting Period, Revenue Growth

In the first step you should set the period for detailed forecasting of future cash flows and assess the growth rate in the years that will follow. The usual forecasting period is 5 years in case of well established company, but can be prolonged for outstanding growth companies or shortened for smaller companies in high competitive industry.

When it comes to forecasting revenue growth, things can get very subjective. This is a difficult part of the analysis. Try to think about all possible aspects influencing company revenues, like future products and services, change in market share, expected changes in pricing policy, etc. You should deal with realistic, optimistic and pessimistic outcomes. The final result of this step is to have sales revenues projections for years to come.

Free Cash Flow

FCF is the cash left to the company once all operating expenses are paid. This is what adds value to company shareholders and can be used for dividend payout, business expansion, research and development, and similar. Projected FCF per year is calculated as sales revenue minus operating costs, taxes, net investment and net changes in working capital. It is not the purpose of this article to get into more details about specific accounting categories, but lets just say that you can find all these figures for recent years in different company statements.

Discount Rate

I cant say how important it is to do the math that follows with correct discount rate, since a very small change in this figure can have a great impact on final result. First of all, why do we have to discount future cash flows? Because of the inflation! $1 after one year is not the same as $1 today, do you agree? In theory you will find many options one could use as discount factor, but WACC is most commonly used (Weighted Average Cost of Capital).

WACC weights the debt and equity cost. The first figure is very straightforward and can be calculated from the balance sheet at what rate is the company paying back its debt. The cost of equity on the other side is usually calculated as a sum of risk free rate (the rate at which you get paid for low-risk investments) and premium for investing in equity (this one depends on the sector/industry beta and market premium).

Terminal Value

So far we have used the discounted cash flow valuation method to determine FCF value for the years in the forecasting period. But the company will not stop operating after this period, will it? So you should determine the value of FCF afterwards. One usual method of doing this is by using the Gordon Growth Model, which simplifies the calculation by assuming that companys CF will stabilize after the last projected year. Terminal value plays an important role in calculating fair company value, so you should rather go more conservative with its calculation.

Enterprise Value

Now we have all the figures to calculate the enterprise value (EV), which is nothing else than discounted cash flow of each projected year and terminal value of the company minus the net debt of the company. Divide the EV with number of outstanding shares to get the fair value of a single share. If the current market price of the same share is trading below the calculated enterprise value, you should consider it as undervalued and a buying opportunity.

Pros and Cons of Discounted Cash Flow Valuation Method

DCF method is useful when comparison of multiples is not possible or makes no sense. It is also a better way to calculate with figures out of cash flow statement than from income statement or balance sheet, which can be adjusted easily.

On the negative side of discounted cash flow valuation method is subjectivity and assumptions. It is also difficult to use this method when the future is not so clear.

We advise you to go as conservative as possible with calculations and bear in mind, that results can only be used for long-term investments. Short-term trading is based more on technical than on fundamental analysis.

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