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Fundamental: A Summary of How to Get Discounted Cash Flow
A summary of how to calculate Discounted Cash Flow (DCF)
Before we start, we must make it clear that this article will not be too extensive and elaborative on the steps needed to calculate the Discounted Cash Flow (DCF) of a stock. If you want a more step-by-step guide, do follow the series that we have published:
This article will just be a general overview of the steps needed for you to see if a stock is overvalued or undervalued via the DCF method.
How to get the fair share value of a stock?
Now, the image above is the formula to see the fair value of a share. Based on that we can tell that there are two components needed to calculate that. Easy? Well, it’s a bit of a rabbit hole situation — not hard at all, but there’s a few steps following it.
Here are the components needed:
- Total Present Value of Free Cash Flow
- Total Number of Shares
For the second one, i.e., the Total Number of Shares, there’s not much trouble with that one. Just Google “(Stock name) outstanding shares” and you’ll probably get the value now. Look below, for example.
The first component, however, is a bit tricky. What does the Total Present Value of Free Cash Flow mean?
Second: Total Present Value of Free Cash Flow
From the above, we know that there are two things needed to get the Total Present Value of Free Cash Flow:
- Net Present Value (NPV)
- Net Debt
In this case, the first one is our door to the second part of the rabbit hole. As the second one, i.e., the Net Debt, all you need to do is open the company’s latest financial statements and look at its balance sheet. Look for two things: “Term Debt (or current year debt)” and “Cash & Cash Balance” (or anything that sounds quite like it). You can also see how we did it in this article: Fundamental: Discounted Cash Flow (Part 5).
After finding it, here’s the formula for Net Debt:
Net Debt = Current Year Total Debt — Cash & Cash Balance
As for Net Present Value, here’s the formula:
NPV = Present Value of Free Cash Flow + Present Value of Terminal Value
Third: Net Present Value
From the formula above, what you need to do is get the Present Value of two things:
In order to get the Present Value of these two, you need to insert the total amount of either the Free Cash Flow or the Terminal Value into this formula:
Present Value = Amount / (1 + discount rate) ^ Number of years
I know there are a few questions in your mind, like:
How do you even get the present value of the Free Cash Flow and the Terminal Value?
For this, I know you hate it when you have to redirect to another article, but it does require a lot more explanation than we care to do in this one, so please have a look into these two:
- Fundamental: Discounted Cash Flow (Part 2)Free Cash Flow
- Fundamental: Discounted Cash Flow (Part 3)Terminal Value
What is the Discount Rate?
A discount rate refers to the rate that you would have if you invested in the next best option you have rather than the stock/asset that you’re eyeing now.
Say, you’re thinking of investing in Apple. How it would look like is that you’ll first take the rate of gains you’d get if you’d invest in safe assets like T-Bills — say, 4.25%. Next, add a few percentages on top of it (assume it, but not too much, maybe around 4–5% extra) and you’ll get around 8% take or give.
Fun fact: this is why the stock market will not be happy when the interest rate is high. It means that the safe assets’ yields are now higher. If you factor that into the formula above, you’ll find that a higher Discount Rate will make the fair value of stocks lower — i.e., the stock will be worth less as an investment.
What do you mean by the Number of Years?
The number of years in the formula refers to the year observed. We know it may sound confusing, but it’s not. If you want to get a better grasp on how it works, you can look into the way we calculated in this article:
Here’s a flow chart on the DCF process:
Quite simple, really.
Here’s what you need to do:
- Look for the company’s free cash flow so that you can get the Present Value of Free Cash Flow and Terminal Value. You can get the free cash flow numbers just by looking at the company’s financial statements.
- Once you get them, add it together and you’ll get the NPV.
- Now, look for the Net Debt by also looking into the company’s financial statements.
- Once you get that, do a calculation of NPV minus Net Debt to get the Total Present Value of Free Cash Flow.
- Once you get the Total Present Value of Free Cash Flow, divide it with the number of shares outstanding.
- You can find the number of shares outstanding by a simple Google search, really.
- That’s it.
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