What Is Discount Cash Flow (2020) |
Discount Cash Flow or DCF is one of the most popular ways to find the fair value of any stock. This method is simple and suitable even for stock marketing beginners who want to learn how to value a stock or how to do stock and equity valuation.
We will understand this with some examples. Suppose you have two options, the first is that you take 100 rupees now and the second option is that you will take 105 rupees after one year. So which option will you choose in both these options?
If I were in your place, the first option would have chosen. Because if we invest 100 rupees in the stock market today, I will get a minimum of 110 rupees after one year. If today I can make it 110 rupees after one year with 100 rupees, then why should I accept 105 rupees?
In this deal, we saw where we are getting better results and which investment we like. If we also take shares, we see whether we will get good returns or not. According to the risk I am taking, we will get returns or not. So for this, we use the discount cash flow method.
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Now you are thinking that where is the discount cash flow on this? This is the exact opposite of compound interest. If you lend 100 rupees to someone today and after 10 years that money will become 110 rupees at that 10% interest.
But if you want a return of 110 rupees on a stock after one year, how much will you buy that stock today so that you can get 10℅ return on it?
When we come from future value to present value then it is called discounting but when we move from present value to future value then we call it compounding.
Until now it was easy to calculate in the example given by me because things were fixed. Because, in this, you know that after one year we will get 110. So we will call this whole process as discounting.
But when we invest in a company, we do not know how much its profit will be after one year or how much will be its profit after 5 years.
So first we have to find out how much the company’s profit will increase by 5 years and then through the discounting, we will find out the present value of that profit today.
Discount Cash Flow Analysis
Whenever we have to find the discount value of a company, we have to do two things. First of all, we have to estimate the cash flow and then do the discounting.
Cash flow: When you start a business, the cash profit you are getting is called cash flow. That is, the profit that has come to your account is the same cash flow. The profit that is going to be received now, we will not call it cash flow.
Free Cash Flow: If we are starting a business, then you will invest the profit from it in your business so that your business can be increased. But despite investing, there is still some profit left in us which we call free cash flow. That is, the amount left with us after spending the entire expenditure is called free cash flow.
Discounted cash flow formula
You will need these 4 steps to analyze discount cash flow. It has been used in the discounted cash flow formula.
1) Initial free Cash Flow:
In the last 3 years, when a company generates an average free cash flow, then that average amount is called Initial Free Cash Flow. Suppose a company kept a cash flow of 100 rupees in 2018, 150 rupees in 2019 and 200 rupees in 2020, then its average amount is (100+ 150+ 200/3 = 150). So here, 150 rupees will be my initial free cash flow.
2) Growth Rate:
For this, we collect the growth rate data for the last 5 years of a company so that we can estimate how much the company will grow in the future. Suppose a company has been growing at the rate of 10 percent for the last 5 years, then we must assume that this company will grow on at least 8 percent growth rate for the next 10 years.
3) Terminal Growth Rate:
In this, it is estimated at what growth rate the company will grow after 10 or 15 years. You should take it 1 or 2 percent only.
4) Discount Rate:
If you invest money in a company, then you expect a good return, then the same expected return is called the discount rate. When you have collected all these data, you can derive discount free cash flow from the below-given discounted Cash Flow formula.
CF=The cash flow for the given year.
CF1 is for year one,
CF 2 is for year two,
CFn is for additional years
r= The discount rate