By Sarah Luke - Vanderbilt University
Would you believe me if I told you that investors can see into the future? How else would they predict the success of companies like Facebook and Google?
Well….maybe they don’t actually have supernatural powers. Instead, they use what is called a Discounted Cash Flow Model, or “DCF”, to determine the future value of a company. This method of valuing a company is based on the amount of cash a company could generate in the coming years. The following steps outline how you, too, can attempt to become a psychic investor. Check out the steps to a Discounted Cash Flow Model:
Project it Out: Free Cash Flows
Typically, you want to project cash flows of a company five to ten years into the future. Estimate a company’s future cash flows by projecting future revenue growth, working capital, and capital expenditures to arrive at the cash flow left over from the company.
Let’s take a step back. What does project mean and where would you even find a company’s revenue to project out? All public companies must report Annual Reports which you can look up on their website. Within an annual report, you can find the Income Statement and the Balance Sheet. These are your starting points to build your projections.
Discount it Back: What are Those Cash Flows Worth Today?
Now that you have projected out a company’s cash flows for the next 5 or so years, we want to figure out the value of these cash flows would be today. Why would the value be different? Ever heard of that old concept “time value of money”? Yup, a dollar is worth more today than it is in the future because of things like inflation. Meaning that cash flows in 5 years have a different value than they do right now.
So how do we calculate the value today (known as the Net Present Value)? We need a discount rate, which is typically called the weighted average cost of capital, WACC (but we can save the fun of that calculation for another day).
Determine the Terminal Value and Discount it
So we projected out cash flows about 5 years into the future. But the company will likely still exist after 5 years, right? Let’s hope so. The Terminal Value is basically a way to calculate what the company will be valued at as it becomes a mature company. It’s kind of tricky to predict past 5 years with reasonable assumptions which is why investors use the the Gordon Growth Model to get an measure of this rate.
Get to the Fair Value and Compare
Once you have the discounted value of the company today, you can determine the fair value of the company shares divided by the number of shares outstanding to see whether our share value is higher or lower than the current share price. This will help decide if the current value of the company is undervalued (cheap) or overvalued (expensive). Seriously, be proud if you understood this even a little.
Why Does this Matter Again?
To remind you, the future value of a company can be used to make smart and knowledgeable investments. Let’s say you have $1,000 to invest in a Company A whose future value is $500, or Company B whose future value is $2,000. Which do you take? Invest in Company B because you get a higher return.
Who Uses this Information?
Investment banks use the future value of a company to determine whether or not one company should buy or merge with another. Equity researchers use this value to determine if a company’s stock is worth buying. If it is, asset managers could include the stock in a client’s portfolio. HINT: If you are applying for an internship or job at one of these places, you will likely be asked to do a DCF.
Still not making sense?
If you want to learn more about the future value of a company, DCFs, or other valuation methods for interview preparation (or a leisurely read), check out the Vault Guide to Finance Interviews.
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