02 July 2014

Discounted Cash Flow Method in Shares Investment

Discounted Cash Flow method is one of the valuation method in determining intrinsic value of a company. The investors can compare the value derived from DCF method with market shares price before any buy / sell decision made. 

The DCF method is based on the assumption that the company would be able to generate positive operating cash flows minus net capital expenditure requirement in long run. Operating cash flow is the cash flow derived from operating net income after adjusting non-cash items such as depreciation & amortization and working capital changes etc. You can retrieve the operating cash flow from cash flow statement and then minus off the net purchase of PPE to get the final figure of free cash flow. 

The concept of free cash flow is that, the company would decide whether to further expand the business or to return it back to shareholders as dividend. But of course, it also depends on company's dividend policy. Some companies would use fixed dividend payout ratio in the dividend policy where some institutional investors would prefer this policy as it is easier to be calculated as the investors would focus more on EPS growth. Some companies would distribute dividend after calculating the cash flow they need to expand the business & operation. 

The discounted free cash flow method cannot be applied to all the companies listed in stock exchange due to the main reasons such as the company is in the growing stage where it consume a lot of cash to expand the business (in another word, it requires additional cash flow to support the business expansion plan besides the original cash flow generated from operating) or the company is suffering from operating losses. In initial growth stage, the company would require additional working capital requirements such as the credit sales to clients as well as building up inventories for the preparation of clients' needs. So, what the company could do is through financing cash flows - either they raise up the right issues (equity) or through selling company bonds (debt). 

So free cash flow is the key indicator here: 
  1. The company no longer require additional financing cash flow to have a sustainable business. In fact, they could reduce the debt level by paying back to bondholders / creditors with the free cash flow. It could also increase credit ratings of the company and further reduce the interest rate paid to the bond holders. 
  2. The company is now in mature stage, where it is now in rather stable business operating environment where it does not require huge cash outflow for working capital requirement.  
If you look at long run, those companies with free cash flow would be able to sustain their business even during financial crisis as they normally have lower debt level as well as they could easily adjust their strategy to increase / maintain their market shares in worse business environment compared to those companies which have debt covenants that require them to scale down the operation / cash outflow. 

Back to the Discounted Cash Flow method here. You can collect all the free cash flow generated by the company over the past years and have your own projection of free cash flow for next few years (It requires you to have deep understanding of the company business model). After that, you could discount all the future FCF by the estimated discount rate. The discount rate could varies depending on the stability of the figures. Normally you would need to include ERP (Equity Risk Premium) into the risk free rate (e.g. the bank saving rate) to derive the discount rate. 

To summarize, you would need to have better understanding of the business model of the company in order to have a better forecast on future free cash flows as well as a suitable discount rate to discount all the future cash flows back to present value. Discounted cash flow method is suitable for those companies in mature stage as they require lesser capital outflow for additional PPE / working capital. 

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