Discounted Cash Flow (DCF) Valuation Basic – Part I

There are three major categories of stock valuations, namely Relative Valuation Model (or Multiplier Model), Present Value Model (or Discounted Cash Flow Model), and Asset-based Valuation Model. 

The Relative Valuation Model uses financial multiples such as Price to Earnings (PE), Price to Book (PB), and Enterprise Value (EV) over Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) etc, to evaluate the stock.  Multiples are seldom used independently.  Most of the time, investors like to compare multiples of several companies in the same business field to make investment decisions.

The Present Value Model, or DCF model, estimates the value of a company using projected future cash flow such as dividend (Dividend Discount Model), or Free Cash Flow (FCF) Model, and then discounted the future cash flow to present value.  It is more complicated than multiplier model because some of the key parameters of the model are not readily available, and the future cash flow stream is hard to estimate.

Asset-based Valuation Model values a company by subtracting the value of liabilities and preferred stocks of the company from the estimated asset value.  This model is used when the company future cash flow stream is uncertain, losing money, or the company is in distressed condition.

These series of articles will focus on DCF model, particularly on FCF model as DDM model was discussed in previous articles (Read more here).  To understand FCF model, few fundamental concepts need to be explained before we dive into Excel spreadsheet to churn out the value.  The three basic concepts are:

1.      Time value money;

2.      Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE); and

3.      Weighted Average Cost of Capital (WACC) and cost of equity.

Let’s begin with time value of money.  Example, if you are going to receive RM100 from an investment in one year time, how much would you pay for the investment today, if you expect your investment return is 5%?  Mathematically, it can be estimated by

5% is the discount rate for your investment, one of the important parameters of DCF model.  Now you see that the RM100 (future value), is worth only RM95.23 (present value) today.  How about an investment that will pay you RM100 every year for 3 years, how much would you pay for it if your required rate of return is 5%?  The math looks like this,

Simple right?  Last example, if you expect an investment will pay you RM100 every year indefinitely, how much would you pay for it if your expected return is 5%?  And here we go,

You can easily compute the value using Excel spreadsheet or Google Sheet.