Discounted Cash Flow
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What is DCF?
The Discounted Cash Flow Model can be used even if a company doesn’t pay a dividend or has unpredictable dividend returns.
To calculate the value of a share using the Discounted Cash Flow Model, add up the value of future earnings, then discount the earnings by the weighted average cost of capital, or WACC.
Then, subtract net debt from the enterprise value to compute the company’s fair value and divide by the number of outstanding shares to calculate the value of a share.
Discounted Cash Flow Formula
The formula for DCF is as follows:
Take the future cash flows for year.
Then divide by one plus “r,” which represents the discount rate, or WACC, raised to the first power.
Then, add the future cash flows for year 2.
Divided by one plus “r,” or the WACC, raised to the second power.
And continue this sequence using a detailed forecast for five years, then add a terminal value, which is the present value of future cash flows in perpetuity.
Once you have the enterprise value, subtract the net debt of the company and divide by the number of outstanding shares.
Discounted Cash Flow Analysis
If the estimated value of a share using the Discounted Cash Flow Model is greater than the current value of a share, the DCF model suggests it is a buying opportunity.
The weakness of this model is that it relies entirely on future cash flows estimates, which are unknown.
Additionally, appraising the cash flows and discount rates incorrectly can lead to inaccurate conclusions on the attractiveness of the investment.