I'm a huge proponent of discounted cash flow model analysis because it's the most reliable formula for evaluating stocks. Benjamin Graham, the father of value investing, used discounted cash flow formulas to evaluate his holdings, so let's take a quick lesson from ol' Ben.
What is the Discounted Cash Flow Model
DCF analysis calculates the present value of a company's future earnings. In other words, what is the value of a company's stock assuming their earnings grow at a certain rate over a given time period. We can figure out what an investment is worth to us today by entering 4 parameters into our model.
Four DCF Parameters
- Earnings Per Share over the past 12 months – we enter the latest EPS as our earnings starting point.
- Earnings Growth Rate over next 5 years – we use the earnings growth rate to calculate a company's forward EPS for the next 5 years. Also known as the analyst's projected earnings growth estimates.
- Growth Rate after 5 years– In order to generate an rational stock price, we enter a conservative growth rate after the initial 5 years. I usually enter 0% as the leveling off growth rate because you should never assume EPS growth for more than 5 years in advance. Companies produce negative earnings all the time, so we must enter a conservative value to make our discounted stock price more precise.
- Discount Rate – This is the most difficult number to derive because it differs between small, mid, and large-cap stocks. The discount rate is the expected return on your investment in 5 years time if purchased during present times. I use annual index returns as my discount rates because these indices represent a large number of securities which produce actionable average return values. An index return will keep your discounted cash formula from returning outliers. I use 15%+ for small-caps, 11% to 15% for mid-caps, and 8% to 11% for large-cap stocks.
When we enter these 4 factors into our discounted cash flow calculator, it returns a present day value of future earnings. Anytime investors like Benjamin Graham highlight the importance of evaluation formulas, we pay attention. Now that you know about discounted cash flow, you can add another useful model to your arsenal of investing tools.
Take Discounted Cash Flow With A Grain of Salt
DCF analysis is a tool and should not be the sole reasoning for a particular investment. Formulas and metrics are only as good as the numbers and values we enter into them. If you find an investment that's highly discounted, try to figure out why the stock is so discounted and look over your values again. It's easy to make a mistake and compute an irrational number as well.
If you use discounted cash flow analysis, what's your opinion on its effectiveness?