In the past article we have seen how Discounted Cash Flow (DCF) is the most appropriate method of stock valuation because it is rational and objective. Now, it is time we have a look at the details of this model.

Present Value of Expected Future Cash Flows

The basic of this model seems to be simple. Any company is only worth as much as it will generate in cash flows over its lifetime. So, we need to estimate the lifetime of the company, we need to estimate the cash that the company is expected to turn in during this lifetime. Then we should discount the cash flows reflecting the risk and time duration. Adding up those cash flows should give us the present value of the firm in theory!

Cash Flows, Not Profits or Dividends

Now, it is important to realize that we are discounting cash flows. We aren’t discounting profits. This is because, profits are subjective. Management has significant discretion over the amount of profits that it wants to report. Also, profits really are an opinion. Dividends on the other hand are just monies paid out to shareholders. Dividends do not reflect profitability. A company could go into loss but still pay a dividend. In fact, many companies do that! So, dividends also aren’t really a good barometer to judge the performance of a company.

Besides, the company can invest cash for further growth of their business. So the opportunity cost for the company really begins when cash comes in the door. Hence cash flow is used and hence the model is called discounted cash flow model.

The Problem with Perpetual Existence

Now, we earlier stated that the process begins with estimating the life of the company. Here is a real problem! The company does not have a finite life at all. The company is a legal person created by law. Legally they have an infinite life. This feature of a corporation is called perpetual succession. Now, this poses real problems when it comes to valuing shares because this means that our cash flows are expected to go on till eternity! How can you value an infinite series of future cash flow payments? Well, we cannot until we make some assumptions. Those assumptions are discussed below.

Two Step Model

To arrive at a value for a company’s stock, we need to split the calculation into two parts. The first part is called the “horizon period”. This is the period for which we will estimate the cash flows with a good degree of precision. This period is generally 4 to 7 years and is the choice that an analyst needs to make. Since this is a finite series of cash flows we can easily discount it and come up with a finite value.

The remaining part of the life of the stock is considered to be a growing perpetuity. So the analyst must make an assumption regarding the constant rate of return that is assumed to be earned by the company till perpetuity. This constant rate must be less than the discounting rate. This makes it an infinitely decreasing series. Mathematically we can come up with a finite value for an infinite set of numbers if their value is decreasing. Hence, we can come up with a finite value for the perpetuity as well.

In the end we need to add up the value of the horizon period as well as the perpetuity to get the discounted value of cash flows. This is how the discounted cash flow model is used to arrive at a stock valuation.