What is Discounted Cash Flow?

last updated

How much should you pay for a stock? That depends on how much money you want to make! Obviously you want to buy at a low price and sell at a high price, but what do "low" and "high" mean? Can you even predict them?

All of Trendshare's investment guide focuses on of value investing. This means finding stocks trading for less than what the company will earn in the future makes them worth. Remember "earnings"; the success of the underlying business is important to the performance of the stock.

How do you get from earning potential to a working definition of value? Start by calculating the desired return on your investment.

How to Calculate Investment Returns

Suppose you buy a doughnut store for \$100. (Maybe it's a little roadside stand in the wilds of Canada, and that's why it's such a bargain.) Business is good, but you hate getting up at 4 am, so you sell it a year later for \$250. You've made \$50: a 50% return in a year.

Suppose you decide you'd rather buy a coffee stand where at least you can sleep in until 5 am before the commute starts. You think you can sell it next year for \$300. You'd like to make another 50% return on that investment by then. At what price must you buy the stand this year to achieve that? That's right—\$200.

That simple math provides a specific dollar amount at which you can buy and sell this business. If you can hit those targets, you'll make made a very good return on your investment. Your question is now "Can I sell this coffee stand for \$200 next year?" If so, it might be a good investment. In practice, you also must consider what it costs to run the coffee stand, though if it'll be worth 50% more than what you paid for it, it's probably a well run business.

Think about the implications of that for a second. If it's plausible that the business will be worth that much next year and if it's plausible that you can sell it for that amount, you're great. If either of those is unlikely, you know that you can move on to the next investment opportunity.

What is Free Cash Flow?

With that working definition of investment value, and the understanding of rate of return tied to the prices at which you buy and sell something, you can understand cash flow.

Free cash flow is the amount of real money a company generates for its owners—its shareholders. This is the money that can be reinvested in the business to help it grow, paid out as dividends, used to buy back stock, or put into play to buy other companies to expand the market, customer base, or types of business.

There are several ways to measure business cash flow, but by the simple and useful defintion, free cash flow is the amount of cash a business has after it pays for its standard upkeep and expansion. Once your business has paid what it needs to pay to stay in business (or build other doughnut carts), what's left over is free cash.

Free cash flow is one of the best measurements of business success in investing, because it's tied the fundamental performance of the business and it's difficult to fudge with accounting tricks. You may hear of EBIDTA, OEBIDTA, and other accounting terms, but when it comes time to write checks to vendors and pay employees, there's nothing better than free cash in the hand. That's what makes free cash flow such a great measure of the value and growth of a business.

What is Discounted Cash Flow?

How does cash flow relate to an investment's price? You have to correlate the money you expect a business to generate to the return you want to achieve from owning that investment. Discounted cash flow is the present value of the free cash an investment can generate. That sounds like a mouthful of math, but it's straightforward. The amount you invested plus the percentage rate of return you want equals the price you have to sell it for. That works great if you know the amount you invested and the return you want to get, but what if you're trying to figure out the right price to pay?

This is middle school algebra. If you know two of the three values, you can figure out the other. If you have the opportunity to buy a cupcake shop (where you can sleep until 10 am and then start making cupcakes for happy hour) now and think you can plausibly sell it next year for \$600, and if you want to make another 50% return on your investment in a year, you can figure out how much you want to spend on it right now. The right price times 1.5 (or plus 50%) equals \$600, so \$600 divided by 1.5 equals the right price right now. If you pay no more than \$400 now, you can meet your goal.

What is Present Value?

In all of the examples (doughnut stand, coffee stand, cupcake shop), the underlying business grew in value over time. If that growth rate is reasonably predictable, you can figure out what the business is worth right now if you have a time frame for selling it. The present value of an investment is the price you should pay for the investment given its expected growth rate.

If you expect your doughnut stand to be worth \$200 next year and you want to make 50% in a year, you can pay no more than \$100 for it right now. Given a time frame of one year and your expected rate of return, the present value of the business is \$100. If it costs you more than that, it's not a bargain. If it costs you less, it's on sale.

In real life, you're unlikely to see discounts this steep. In the stock market, they sometimes occur. Is a 50% return realistic though? Over a period of decades, the S&P 500 index fund returns somewhere around 8% a year. That's the simplest buy-and-hold strategy you can pursue in the stock market, and it's pretty reliable over time. If you take away only one hot investment tip, it's this.

To beat the stock market you must earn more than 8% a year. Give yourself a little bit of safety and look for 12%. To find a bargain in the stock market, you want a discounted cash flow value of about 12%. (Trendshare uses 15% to provide a more conservative margin of safety.)

What is Discounted Cash Flow Analysis?

Put together all of these ideas. Discounted cash flow analysis is a financial measurement which helps you answer the question "What should I pay for a share of a company, given its cash flow situation and the rate of return I want to get?"

In this case, the value of a share of stock isn't exactly what you think you can sell it for in the future. It's related more closely to the amount of free cash the company will generate for each share of stock. This assumes that the value of each share of stock will eventually reflect a fair valuation of that free cash flow, though it allows that the market can be irrational at times. The interplay between these two trends provides value investors with the opportunity to find bargains!

This math does get a little bit more complicated, but you don't have to understand all of the details if you understand the goal. \$100 invested at a 50% rate of return will give you \$150 next year. If you know something worth \$150 next year and you want to make a 50% return, you can pay no more than \$100 for it right now.

How to Find Discounted Cash Flow

Because of the volatility of the stock market and the unpredictability of cash flow (see Free Cash Flow Jitter for a measurement of the reliability of a company), you want to add a measure of risk insurance to your calculations. By discounting the final price, you give yourself a margin of error. If there's a 10% risk that the cupcake shop won't be worth \$600 next year, take 10% off the \$400 price and resolve to pay no more than \$360 for it.

In practice, this means find a good stock you like. Make sure it has reliable cash flow and a good market position. Determine the likelihood that the company will stick around and do good things. Calculate the cash flow out five or ten years, taking into account the past five or ten years of cash flow or owner earnings.

Choose your discount rate and figure out the present value of the company based on its expected cash flow. Apply your margin of safety.

You now have a target number. If the stock price is at or below that number, it's probably on sale. Keep investigating until you're comfortable investing. Otherwise, move on. Then, buy and hold.

Congratulations! You're a value investor.