Valuation Techniques I: Discounted Cash Flow

Value Investing consist simply on investing in assets whose intrinsic value is considerably lower than its market price. Therefore, the only two things that we have to take into account when we want to invest our money are current price of the asset and its intrinsic value. It seems very simple, but it’s not. As Jesse Livermore, one of the most brilliant investors, said:

“If you have one minute I’ll tell you how to earn money in the stock market. Buy at low prices and sell at high prices. If you have 5 or 10 years I’ll tell you when prices are low and when they are high.”

Discounted Cash Flows

There are several methods to calculate the intrinsic value of an asset. One of the most used is the Discounted Cash Flow (DCF) method. This valuation technique consists of calculating the current value of the asset discounting future cash flows to their current value. In order to do this, we use a discount factor, which is our required rate of return for that asset. This is its formula:

Let’s see an example of how it works. Let’s imagine that we have an asset whose expected cash flows for the following years are:

Year 1: 1000

Year 2: 1050

Year 3: 1200

Year 4: 1550

Year 5: 1400

Year 6: 2000

Moreover, let’s suppose that our required rate of return is 8%.

After calculating the discounted cash flow, we have the value of 6,131.18 € for the asset. This means that if we pay 6,131.18 € for this asset now, it will give us 8% annual yield during the next 6 years. If our discount factor was, for example, 10%, the value of the asset would change to 5,735.35 €. I have uploaded this excel file in which you can see the calculations and you can change the different values of the cash flows and discount factor and see how the value of the asset changes. It is important to get used to use excel spreadsheets in financial asset valuation because it is a very useful and complete tool in which we can calculate values in an easy way.

The problem of using discounted cash flow model in company valuations is that it is not as straightforward as it looks. Firstly, we have to select the appropriate discount factor, which will be different for each investor and will depend on the equity and the expected return of the investor. Another problem is that we are taking into account FUTURE cash flows, so we are forecasting something that we don’t know accurately. Sometimes we will not have any idea at all. For example, anybody could forecast Google's or Apple's profits in 5 or 6 years time?

In forthcoming articles we will study more in depth discounted cash flow method and other ways of asset valuation, such as the use of multiples, real options and other qualitative valuation methods.

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