How DCF used to predict stock price
Discounted Cash Flow (DCF) analysis is a valuation method used to estimate the value of an investment based on its expected future cash flows.
Here’s how DCF is used to predict stock prices:
Estimate Future Cash Flows:Free Cash Flow to the Firm (FCFF): This is the cash flow available to all investors (both debt and equity holders) in the company. It’s calculated as: [ \text{FCFF} = \text{EBIT} \times (1 – \text{Tax Rate}) + \text{Depreciation} – \text{Capital Expenditure} – \text{Change in Net Working Capital} ]
Free Cash Flow to Equity (FCFE): This is the cash flow available to equity shareholders. It’s calculated as: [ \text{FCFE} = \text{FCFF} – \text{Interest Expense} \times (1 – \text{Tax Rate}) + \text{Net Borrowing} ]
Project Future Cash Flows:
Forecast the FCFF or FCFE for a certain number of years into the future (typically 5-10 years). These projections are based on assumptions about revenue growth, profit margins, capital expenditures, changes in working capital, etc.
Determine the Discount Rate:Weighted Average Cost of Capital (WACC): For FCFF, the discount rate is usually the WACC, which reflects the company’s cost of equity and debt. [ \text{WACC} = \left(\frac{E}{V}\right) \times \text{Cost of Equity} + \left(\frac{D}{V}\right) \times \text{Cost of Debt} \times (1 – \text{Tax Rate}) ]
Cost of Equity: For FCFE, the discount rate is the cost of equity, calculated using models like the Capital Asset Pricing Model (CAPM). [ \text{Cost of Equity} = \text{Risk-Free Rate} + \beta \times (\text{Market Risk Premium}) ]
Calculate the Terminal Value: Since it’s not practical to project cash flows indefinitely, a terminal value is estimated to account for the value beyond the projection period. This can be done using the Gordon Growth Model: [ \text{Terminal Value} = \frac{\text{Final Year’s Cash Flow} \times (1 + g)}{r – g} ] where (g) is the perpetual growth rate of the cash flows, and (r) is the discount rate.
Discount Cash Flows to Present Value: Discount the projected cash flows and terminal value back to their present value using the discount rate. [ \text{Present Value of Cash Flows} = \sum \left( \frac{\text{Cash Flow in Year t}}{(1 + \text{Discount Rate})^t} \right) ] [ \text{Present Value of Terminal Value} = \frac{\text{Terminal Value}}{(1 + \text{Discount Rate})^{\text{Final Year}}} ]
Calculate the Intrinsic Value: Sum the present values of the projected cash flows and the terminal value to get the total enterprise value (for FCFF) or equity value (for FCFE). For enterprise value, subtract net debt to find the equity value.
Estimate the Stock Price: Divide the equity value by the number of outstanding shares to estimate the stock price. [ \text{Stock Price} = \frac{\text{Equity Value}}{\text{Number of Outstanding Shares}}
]Summary Example:
Forecast FCFF for 5 years: Year 1: $100M, Year 2: $110M, Year 3: $121M, Year 4: $133M, Year 5: $146M.
Determine WACC: Assume WACC is 8%.
Estimate Terminal Value:
Assume a perpetual growth rate of 3%.
Discount Cash Flows: [ \text{PV of Cash Flows} = \sum \left( \frac{\text{FCFF in Year t}}{(1 + 0.08)^t} \right) ] [ \text{PV of Terminal Value} = \frac{146M \times (1 + 0.03)}{0.08 – 0.03} / (1 + 0.08)^5 ]
Sum the Present Values to get the total enterprise value.
Subtract Net Debt (if using FCFF) to get equity value.
Divide by Outstanding Shares to estimate the stock price.
DCF provides a thorough valuation based on expected cash flows and appropriate discount rates, though it relies heavily on the accuracy of the projections and assumptions used.
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