The discounted cash flow (DCF) model is used to value stocks. The metric provides us with an idea of the value of a stock over the period of an investment, but it can be a tricky one to calculate.
Why use the DCF?
There’s little consensus on the right way to value a share. To start, there are a host of metrics, including the price-to-earnings ratio and the enterprise-value-to-EBITDA ratio.
But these are quite simplistic and tell us little about a stock’s future prospects. They also require us to compare metrics across sectors to understand whether a stock is to be considered ‘cheap’ or not.
The DCF can offer a better way to understand a stock’s value than these near-term valuation metrics, but it does require me to make estimates about future cash flows.
What is the DCF model?
Essentially, the DCF model is a valuation method that estimates the value of an investment using its expected future cash flows.
In conducting a DCF analysis, as an investor, I must make estimates about cash flows over a given period — in theory the length of my planned investment.
But here’s the discounted bit. Each year’s predicted cash flow is then divided by one plus the ‘discount rate’. The discount rate is applied because £1 in next year is worth less to me than £1 now — it’s the time value of money.
It can get complicated, so thankfully there are calculators online to help me. But by adding together DCFs over the investment period, I can come to a net present value, which in turn is divided by the number of shares.
The final figure provides me with an indication of how much each share should be worth according to the data I’ve used.
Using the DCF model now
The vast majority of bourses are down over 12 months. The FTSE 100 is an outlier because it’s been pushed upwards by surging resource stocks that are well represented on the index. But the truth is, most stocks appear cheaper today than they did a year ago.
However, this correction creates opportunity. I need to be aware that stocks often lose value for a reason. But I’d rather invest in a weak market than a strong one as I think I stand a better chance of finding truly undervalued stocks.
So, this is where the DCF model comes in.
By using the metric, I can develop an understanding as to which stocks are actually undervalued, and which ones are cheap for a reason.
For example, a DCF calculation on Rolls-Royce and Lloyds, with a 10-year exit, suggests they could be undervalued by 45% and 60% respectively.
Yes, the DCF model has its pitfalls, as forecasting cash flow over 10 years for these two firms isn’t easy. However, the calculations are certainly more illuminating that a price-to-earnings comparison.
The post FTSE correction: hunting for discounted stocks using the DCF model appeared first on The Motley Fool UK.
Don’t miss this top growth pick for the ‘cost of living crisis’
While the media raves about Google and Amazon, this lesser-known stock has quietly grown 880% – with a:
Greater than 20X increase in margins
Nearly 60% compounded revenue growth over 5 years – more than Apple, Amazon and Google!
A 3,000% earnings explosion
Of course, past performance is no guarantee of future results. However, we think it’s stronger now than ever before. Amazingly, you may never have heard of this company.
Yet there’s a 1-in-3 chance you’ve used one of its 250 brands. Many are household names with millions of monthly website visitors, and that often help consumers compare items, shop around and save.
Now, as the ‘cost of living crisis’ bites, we believe its influence could soar. And that might bring imminent new gains to investors who’re in position today. So please, don’t leave without your FREE report, ‘One Top Growth Stock from The Motley Fool’.
Claim your FREE copy now
setButtonColorDefaults(“#5FA85D”, ‘background’, ‘#5FA85D’);
setButtonColorDefaults(“#43A24A”, ‘border-color’, ‘#43A24A’);
setButtonColorDefaults(“#FFFFFF”, ‘color’, ‘#FFFFFF’);
})()
More reading
2 dirt-cheap shares I’ve bought to hold for 30 years!
2 FTSE 100 stocks and 1 investment trust I’d buy for passive income!
I’d use this once-in-a-decade chance to grab cheap shares for a £20k Stocks & Shares ISA
4.6% and 9.7% yields! Should I buy these cheap FTSE 100 dividend shares?
Entering 2023 with no savings, I’d follow Warren Buffett and start building wealth
James Fox has positions in Lloyds Banking Group Plc and Rolls-Royce Plc. The Motley Fool UK has recommended Lloyds Banking Group Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.