Discounted cash flow - Essay Example

One of the valuation tools that analysts use to determine the stock valuation is discounted cash flow. They try to determine current value estimating future cash flows. Cash Flow is taken into account while making all estimations. Cash Flow (Free) gives far clear picture about the company for it takes into account the change in working capital as well as all investments made during the period. It can be expressed as under. Cash Flow = Net Profit+ Depreciation/Amortization-Expenditures-changes in working cap.

Analysts take into account cash flows because it is difficult to manipulate while earnings can be manipulated and adjusted. (Free Cash) When estimated cash flows are discounted to the present value as per the cost of capital for the number of years of operation, it gives a clear picture for the benefits accrued from the investments made in the company. Mathematically, it can be expressed as Present Value = CF1/(1+K)+ CF2 / (1+K)2 +CF3/ (1+K)3 +[TCF / (K - R)] / (1+K)n-1 CFi = Cash flow in the year 1, 2,  K = discount rate TCF = Cash flow in the terminal year R= growth rate assumption beyond terminal year n = the number of years including the terminal year In short, above model gives the present value of the company based on the cash flow estimates of the future.

DCF analysis implies that the company is worth all the cash that can be made available to the investors in the future. Future cash flows are discounted to the present value so that comparison becomes possible on investments made and benefits accrued. All future benefits of the investments made accrue at different time intervals, for example, at the end of year 1, 2, 3, and so on. Methodology and formula is same for all the analysts yet end results will differ for the following reasons. 1. The Discount Rate taken into calculation will be different for different analyst.

The discount rate is usually the cost of capital. Each company is made of debt and equity in its capital structure. The cost of debt can be known easily as per the going rate in the market but estimating the cost of equity is a bit complicated task where each analyst applies his or her judgment. The equity is shareholder’s money and not without the cost. It has also certain indirect cost implications. The share holders of the company expect to obtain a certain return on their equity investments.

Equity is a risk capital and depending upon the general economic conditions of the market, share holder wants certain minimum return over and above risk free return available to them in the market. If the company does not meet shareholder’s expectation, they will simple exit from the company. That will cause the fall in the market price of the shares. In other words, the company must give some minimum return to the shareholders to maintain the price of shares in the market. This is, in a way, the cost of equity for the company.

Every analyst will have own perception on this cost of equity. Thus, each analyst will have some different discounting factor in their mind. This will also vary as per the economic conditions of the country and risk factors associated with the company. 2. Cash Flow Forecast is another critical parameter where two analysts estimate always differ. It is always easy to forecast the cash flow for a few years down the line but it is not possible to have these estimates without error beyond few years.

Each analyst’s perception about future market conditions and overall economic scenarios come into play. Some analyst may have a cautious approach in estimation of future cash flows while other may be a bit liberal or optimist in the projections. It is obvious that this will have a bearing on the valuation of the stock and cause variance on valuation of the stock. (Free Cash) 3. The Growth Rate beyond the terminal year is a long visionary assumption. Farther we go, more difficult it becomes to arrive at the agreement on values.

When company reaches to the maturity cycle after a few years of operation, it