Discounted Cash Flow (DCF)

Discounted Cash Flow (DCF): is a way of valuing companies by forecasting flow for a period of years into the future and applying a discount factor to each year’s figure to reflect the expected time until it accrues. The further in the future, the greater the discount applied to that year’s cash flow. (Think about it, if I owe you $100 and promise to pay you next week–you are OK with it, nut if I promise to pay in 9 years, you have some concerns, right? This discounting idea shows the decay in value of a dollar for every additional year it takes you to actually see it arrive in you pocket.)

The discounted cash flows for each of the years are added together, and additional value is placed on the total cash expected to accrue beyond that point, and the total is then compared with the market value of the company.

DCF = Free cash flow year 1 X (discount factor for year 1)…etc… +Free cash flow year 10 X (discount factor for year 10) + PV (value to perpetuity)

Using DCF is a good way of getting a handle on whether a particular share represents good value or not–and it’s solid based in earnings. The challenge is to accurately project an accurate discount factor and the company’s earnings growth rate into the future. Warren Buffet uses DCF to value companies he invests in, and since he’s the greatest mind in equity investing today (or any day), we should strive to learn this method. Buffet advises we focus on being approximately right, and not precisely wrong-otherwise, don’t get bogged down in the details but see the bigger picture. Prof Sage will present a short-version of Intrinsic Value below.