What is Discounted Cash Flow?

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Discounted cash flow helps investors decide how much to pay for an investment based on the money the company generates.

How much should you pay for a stock? That depends on how much 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 value investing—finding stocks trading for less than what the company will earn in the future makes them worth. Earnings are important; the success of the underlying business predicts 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.

What Does an Investment Return?

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 $150. You've made $50: a 50% return in a year.

Suppose you decide to buy a coffee stand and sleep in until 5 am. You find a good candidate, and your sales projects suggest that you can probably flip it next year for $300. That 50% return from last year was so great, you want to do it again. Here comes some math: what do you need to spend right now to make 50% when you sell next year for $300? In Algebra, that's x * ( 1 * 0.5 ) = 300, or x = 300 / 1.5 or $200.

That simple math provides a specific dollar amount. If you can hit those targets of $200 and $300p, you'll make made a very good return on your investment. Your question is now "Can I sell this coffee stand for $300 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.

If it's plausible that the business will be worth that much next year and if it's reasonable that you can sell it for that amount, you've found a wonderful opportunity. If either of those is unlikely, you know that you can move on to another idea.

Free Cash Flow

In practice, the numbers aren't as easy, but the process is the same. The question is still "how do know what a business is worth?". One way of looking at that is to figure out how much money it produces.

Free cash flow is the amount of real money a company makes for its owners—its shareholders. This money 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 definition, 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.

"Real cash", of course, means that you can't count anything in accounts receivable until you actually have the money in hand. Similarly, anything where accounting might let you declare the value of an asset but you can't actually use that asset to pay a bill or send a check to a shareholder or buy something else right now doesn't count. This is truly cash in hand.

Free cash flow is one of the best measurements of business success in investing, because it's tied the fundamental performance of the business. 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 hand. That's what makes free cash flow such a great measure of the value and growth of a business.

Free Cash is Worth Paying For (Discounted Cash Flow)

Cash flow makes sense, but how does it 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. 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. Suppose 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. 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.

In other words, you've figured out what you want to pay based on how much you want to make, just like with the coffee shop and the doughnut shop.

Growth is Worth Paying For (Present Value)

In all of the examples (doughnut stand, coffee stand, cupcake shop), the underlying business grew in value over time. If you can predict that growth rate with sufficient accuracy, 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. With all of the stocks on the market now, opportunities do happen. 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.)

In other words, you need to pay no more than $178.57 for your doughnut stand right now to be able to sell it next year for $200 and make a 12% return.

What is a Share of Any Stock Worth?

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?"

For a stock, the value of a share isn't exactly what you think you can sell it for in the future. That's too difficult to predict, given that you're not buying the business as a whole. If you buy a thousand shares of General Motors, you'll own a fraction of a fraction of the company. With stocks, you have to figure out what you think the business may be worth in the future (which you already know how to do now) and then come up with a fair price for it.

To figure out the value of GM in the future, you can use 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.

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.

Limitations of Discounted Cash Flow

Apart from some middle school algebra which gets easier once you've done it a few times, nothing here is rocket surgery. You do need to keep in mind a few limitations, however.

  • You'll have to skim the accounting statements (10-Ks and 10-Qs) of public companies to figure out free cash. (Or use a service like Trendshare to do it for you.) None of this is complicated, but you're dealing with rough figures that can hide a lot of details. Remember that your figures need to be in the ballpark of correct.
  • The present value calculation depends on the return you want to get. If investor sentiment is happy enough with 4% returns for your stock and your calculations expect a 20% return, you may wait a long time to find the appropriate discount.
  • The margin of safety protects against irrational exuberance and (some) errors of judgment in predicting the future. It won't protect you against everything.
  • Stocks go up and stocks go down. Stocks may be underpriced for a long time, drop in value further, and reach their fair value in years or decades. Patience and caution are the order of the day.

Even with these disclaimers, the value of discounted cash flow is that it reflects the underlying value of the business, it respects the price you want to pay, and it gives you a range of prices where your certainty or uncertainty can guide your choices.

Congratulations! You're a value investor.

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