How to Calculate DCF?
The Discounted Cash Flow (DCF) analysis is a popular method for valuing a stock by estimating its future cash flows and discounting them back to their present value. Here's a structured approach to calculating DCF:
1. Forecast Future Cash Flows
Begin by projecting the company's free cash flows for a specific period, usually 5 to 10 years. Free cash flow is typically defined as cash generated from operations minus capital expenditures. Use historical data, industry analysis, and growth expectations to guide your estimates.
2. Determine the Terminal Value
Since it's impractical to forecast cash flows indefinitely, calculate a terminal value at the end of the projection period to account for all future cash flows. This can be done using the Gordon Growth Model or the Exit Multiple method.
3. Select the Discount Rate
The discount rate is usually the company's Weighted Average Cost of Capital (WACC), representing the average return required by investors. It incorporates the cost of equity and the cost of debt.
4. Calculate Present Value
Discount the anticipated future cash flows and terminal value back to their present value using the formula:
PV = CF / (1 + r)^n
Where CF is the cash flow, r is the discount rate, and n is the year.
5. Sum the Present Values
Add the present values of all projected cash flows and the terminal value to get the total present value of the company.
6. Perform Sensitivity Analysis
It's crucial to analyze how changes in growth rates and the discount rate impact the DCF valuation, helping to understand risks and variability in estimates.
By completing these steps, you can derive the intrinsic value of a stock, helping inform your investment decisions.