When you’re buying stocks, it’s important to understand how much they are worth. One way to do this is by using a method called Discounted Cash Flow (DCF). This method helps you calculate the value of a company based on the money it is expected to make in the future. It sounds complicated, but we’ll explain it step-by-step in simple terms!

What is Discounted Cash Flow (DCF)?

The Discounted Cash Flow (DCF) method is a way of figuring out how much a company's stock is worth by looking at how much money the company is expected to make in the future. However, future money is worth less than money you have today. So, we “discount” those future earnings to get their value in today's terms.

In simple words:

• Cash Flow is the money a company makes.

• Discounted means adjusting the money to its present value because money in the future is less valuable than money today.

Steps to Calculate DCF

There are a few key steps to calculate the DCF. Let’s break them down:

• Estimate Future Cash Flows

First, you need to estimate how much money the company will make in the future. This is usually done for the next 5-10 years. We use the company’s past earnings and growth trends to predict how much money it will make.

• Calculate the Discount Rate

The discount rate is the interest rate that you will use to reduce the future cash flows to their present value. Usually, the Weighted Average Cost of Capital (WACC) is used for this. It’s just a fancy way of saying how much it costs a company to get money from different sources, like loans or investors.

• Discount the Future Cash Flows

After estimating the future cash flows and determining the discount rate, you reduce (or discount) those future earnings to their present value. The formula for discounting is:
Discounted Cash Flow=Future Cash Flow(1+Discount Rate)n\text{Discounted Cash Flow} = \frac{\text{Future Cash Flow}}{(1 + \text{Discount Rate})^n}Discounted Cash Flow=(1+Discount Rate)nFuture Cash Flow​
Where:

• n is the year for which you're calculating the cash flow.

• Discount Rate is the percentage that reduces future cash flow.

• Future Cash Flow is the company’s estimated earnings for that year.

• Sum the Discounted Cash Flows

Once you have discounted all the future cash flows for each year, you add them up. This gives you the company’s present value based on the DCF method.

• Determine the Intrinsic Value

Finally, compare the present value (calculated DCF) with the company’s current stock price. If the DCF value is higher than the stock price, the stock might be undervalued. If the DCF value is lower than the stock price, the stock might be overvalued.

Example of How DCF Works

Let’s say we want to value the stock of a company called ABC Ltd. We’ll use some simple numbers to show how DCF works.

Step 1: Estimate Future Cash Flows

We assume that ABC Ltd. will make the following cash flows over the next 5 years (in ₹ Crores):

Step 2: Calculate the Discount Rate (Assumed 10%)

We will use a discount rate of 10% for this example. This is the rate at which future cash flows are reduced to the present value.

Step 3: Discount the Future Cash Flows

We will now discount each year’s future cash flow using the formula:

Discounted Cash Flow=Future Cash Flow(1+Discount Rate)n\text{Discounted Cash Flow} = \frac{\text{Future Cash Flow}}{(1 + \text{Discount Rate})^n}Discounted Cash Flow=(1+Discount Rate)nFuture Cash Flow​

Where:

• Future Cash Flow is the projected earnings for that year.

• Discount Rate is 10% (or 0.10).

• n is the year number (1, 2, 3, etc.).

Let's calculate it:

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Step 4: Sum the Discounted Cash Flows

Now, we add up the Discounted Cash Flows for each year to get the total present value:

Total Discounted Cash Flow=₹90.91+₹90.91+₹90.15+₹88.92+₹86.86=₹447.75\text{Total Discounted Cash Flow} = ₹90.91 + ₹90.91 + ₹90.15 + ₹88.92 + ₹86.86 = ₹447.75Total Discounted Cash Flow=₹90.91+₹90.91+₹90.15+₹88.92+₹86.86=₹447.75

Step 5: Compare with Stock Price

• Total Present Value (DCF) = ₹447.75 Crores.

• If the company’s current market value or stock price is ₹450 Crores, then based on this DCF analysis, the stock appears to be fairly valued.

• If the stock price is lower than ₹447.75 Crores, it may be considered undervalued.

Key Takeaways from DCF

1. It Helps Determine the Value of Future Cash: By considering how much money a company will make in the future, DCF gives you an idea of what the stock is worth today.

2. It's a Long-Term Tool: DCF is great for long-term investors because it shows the intrinsic value of the stock based on its future potential, rather than short-term market fluctuations.

3. Compare DCF with Current Stock Price: To make an informed decision, compare the DCF value with the current stock price. If the DCF value is higher, the stock might be a good buy.

The Discounted Cash Flow (DCF) method is a powerful way to understand the true value of a company’s stock. It helps you look beyond just current numbers and see the potential of a company’s future earnings. By calculating the DCF, you can make better decisions and choose stocks that are undervalued or fairly priced. Remember to consider other factors and do thorough research before making any investment.

Read More - How to value stocks using the discounted cash flow method?

Frequently Asked Questions (FAQs) on Discounted Cash Flow (DCF) Method