Discounted Cash Flow Analysis

[robertbanking]

Hello you very wonderful and intelligent individuals that make up this forum. I sincerely hope you have had another successful investing week.

I have been doing alot of Value Investing and for realistic valuations, you look at Total Enterprise Value to get an idea of whether a business is undervalued. For growth stocks, Discounted Cash Flow analysis is one valuation method recommend. I please wondered if anyone knows any books, or online videos, or articles, that explains how to conduct the Discounted Cash Flow analysis with examples please, so you have the tools and know how to calculate this? If anyone could kindly help with this i would be forever grateful and thankful for your support, it would be highly appreciated.

Thank you so much for your support and i truly hope you continue to do extremely well with your investing. Thanks to all the wonderful members of this forum who post so much insightful and knowledgeable posts to benefit everyone. Very best wishes to you and look after yourself.

[tjh290633]

The Excel functions IRR and XIRR are essentially DCF calculations. IRR works on an annual basis, while XIRR can take any date for each event.

Fundamentally you take a cash flow, either from the past or into the future, and the function gives you the rate of return.

TJH

[simoan]

The Excel functions IRR and XIRR are essentially DCF calculations. IRR works on an annual basis, while XIRR can take any date for each event.

Fundamentally you take a cash flow, either from the past or into the future, and the function gives you the rate of return.

TJH

I’m sorry but this is not correct. DCF is much more complex than a simple IRR function. It aims to calculate a present value based on estimated future cash flows using a discount rate:
https://www.investopedia.com/terms/d/dcf.asp

Good luck to the OP. I’ve made my thoughts about the utility of DCF known on a previous thread.

[monabri]

The Excel functions IRR and XIRR are essentially DCF calculations. IRR works on an annual basis, while XIRR can take any date for each event.

Fundamentally you take a cash flow, either from the past or into the future, and the function gives you the rate of return.

TJH

I’m sorry but this is not correct. DCF is much more complex than a simple IRR function. It aims to calculate a present value based on estimated future cash flows using a discount rate:
https://www.investopedia.com/terms/d/dcf.asp

Good luck to the OP. I’ve made my thoughts about the utility of DCF known on a previous thread.

Is it the "D" in DCF that is the issue? If it was just "cash flow" I could go with it but , unless I've misunderstood, DCF and XIRR are not the same.

[simoan]

I’m sorry but this is not correct. DCF is much more complex than a simple IRR function. It aims to calculate a present value based on estimated future cash flows using a discount rate:
https://www.investopedia.com/terms/d/dcf.asp

Good luck to the OP. I’ve made my thoughts about the utility of DCF known on a previous thread.

Is it the "D" in DCF that is the issue? If it was just "cash flow" I could go with it but , unless I've misunderstood, DCF and XIRR are not the same.

The link in my post contains a short video that I thought would be useful to explain how the Net Present Value of an investment is calculated using estimates of future cash flows. The discount rate is absolutely essential to the calculation and there is no need to calculate a “rate of return” so I’m not sure where an IRR function takes you.

Although I understand the basics, DCF is practically useless for valuing equities and IMHO the time of the OP would be better spent calculating the rate of growth of their toenails.

[robertbanking]

Thank you very much for all your replies and thoughts on this, i am very grateful for your support, it does mean alot.

Simoan i very much appreciate the link provided and the video providing details of how the Net Present Value of an investment is calculated using estimates of future cash flow. I please wondered anywhere i could learn how to do this calculations and also how to find the relevant expected growth rates and financials from a companys financial accounts to be able to carry out this calculation please? Can i kindly ask is there a course or book that might explain this please? If you kindly had time to answer this i would be forever grateful it would be highly appreciated.

Enjoy the rest of your weekend Simoan and thanks very much for your support and opinions on this. All the very best to you.

[simoan]

Thank you very much for all your replies and thoughts on this, i am very grateful for your support, it does mean alot.

Simoan i very much appreciate the link provided and the video providing details of how the Net Present Value of an investment is calculated using estimates of future cash flow. I please wondered anywhere i could learn how to do this calculations and also how to find the relevant expected growth rates and financials from a companys financial accounts to be able to carry out this calculation please? Can i kindly ask is there a course or book that might explain this please? If you kindly had time to answer this i would be forever grateful it would be highly appreciated.

Enjoy the rest of your weekend Simoan and thanks very much for your support and opinions on this. All the very best to you.

I wish you well with your investigation of DCF but it is not something I have any interest in, as I thought I had made clear. I once looked at it 25 years ago because it was very popular at the time (in the tech bubble) to explain the ridiculous valuations of companies that did not make any profit. Frankly, it doesn’t work, and the best thing I could possibly advise is that you spend time to better effect investigating other valuation techniques.

[Charlottesquare]

Samuels, Wilkes Bradshaw "Management Company Finance" covers DCF calcs amongst other business finance matters. Examples will be more re internal decision making (should I buy x machine that will give me streams of income over future years etc) but mechanics are similar if one were looking at future cashflows from a share investment.

I will caveat that the various assumptions made are key to the outcome so a mere understanding of the theory does not get you that far applying to something like a share, but even if you cannot apply to share purchases the book itself , albeit now dated, is worth reading- 60p on Amazon here and covers a lot of finance ideas and theories.

It was a core finance book re a degree in accountancy and finance in the 80s/90s. ( S & W was one of two set books in finance in 1984/85 at University of Aberdeen, other was Frear- which I did not like), I think the earlier S & W is a better publication than S.W & B, but that is probably my prejudice as I pored over the earlier one for a lot of hours.

https://www.amazon.co.uk/Management-Com ... 1861522290

P.S, states 1980 but I think later, I bought Samuels and Wilkes in 1984 at Uni, Samuel Wilkes and Bradshaw is a later publication so cannot imho be 1980.

[robertbanking]

Thank you very much for your response Charlottesquare that was very kind of you, i truly appreciate the time you took to leave a response.

I have ordered the book Samuels, Wilkes Bradshaw "Management Company Finance" it seems like this book could be helpful so i am very thankful for your recommendation on this. I would not have found this book so it was helpful you mentioned this was a core finance book regarding a degree in accountancy and finance in the 80s/90s.

Can i kindly please ask lastly for growth stocks like Amazon, if you believe for instance that the Amazon Web Services section of the business, was undervalued at current, and due to its large market share felt this would grow in the future. Alongside lots of other research in to the businesses financials and management, could you buy the stock without doing some of these realistic calculations like Discounted Cash Flow please? If you kindly had time to answer this i would be forever grateful and thankful for your support with this.

Thanks again for being a wonderful person Charlottesquare and for your very amazing help. Have a wonderful week and hope things continue to go well for you.

[Charlottesquare]

Thank you very much for your response Charlottesquare that was very kind of you, i truly appreciate the time you took to leave a response.

I have ordered the book Samuels, Wilkes Bradshaw "Management Company Finance" it seems like this book could be helpful so i am very thankful for your recommendation on this. I would not have found this book so it was helpful you mentioned this was a core finance book regarding a degree in accountancy and finance in the 80s/90s.

Can i kindly please ask lastly for growth stocks like Amazon, if you believe for instance that the Amazon Web Services section of the business, was undervalued at current, and due to its large market share felt this would grow in the future. Alongside lots of other research in to the businesses financials and management, could you buy the stock without doing some of these realistic calculations like Discounted Cash Flow please? If you kindly had time to answer this i would be forever grateful and thankful for your support with this.

Thanks again for being a wonderful person Charlottesquare and for your very amazing help. Have a wonderful week and hope things continue to go well for you.

Sometimes analysts workings can be found for bigger companies, I would more spend time poring through these rather than trying a DIY approach from scratch. Also company briefings can sometimes be found online, whilst biased ,as company directors tend not to trash their own companies, information from these can also be useful.

You need to build a toolkit e.g. accounts, do you really understand them, do you understand what companies need to report, how they must record certain things, have you looked at the particular accounting standards they use, do you understand the raw components of debits and credits etc, working capital cycles etc.

Frankly I doubt I would ever buy Amazon direct, I avoid shares that are not UK listed (the only one I own is Berkshire) and would prefer any Amazon exposure via an IT that owns Amazon shares, accordingly I cannot make any comments re Amazon as have never studied it. Talking about Berkshire, reading Warren's views in his annual address to shareholders might be very valuable education as to "How to Think"

My opinion is that for those without a solid grounding in reading accounts etc DIY share analysis is maybe a waste of time, and even when you can read what they say any time you try to use the accounting figures to estimate value you also make some big and bold assumptions and the more of these you make the more unreliable your valuation. In addition all the numbers and tidy calculations can fool you into believing there is rigour when there is really a lot of estimates and assumptions.

For example company has reported EPS of £0.50, I think a P/E of 10 is appropriate so value at £5.00. Is my 10 reasonable? Well that depends on the Share's peers, growth prospects, how the market is pricing etc, so maybe 10 fine but maybe 8 or 15 are better. I am merely assuming 10 and that is a very significant assumption, is it justified? In fact it may well be a more significant error than digging in the accounts etc and finding the EPS stated is in any way overstated with the more realistic EPS being say 46p , the accounts being "optimistic"

Frankly digging in the accounts to nth degree but then assuming other non accounts factors seems to be precision coupled with waving a wet finger in the air, all the precise accounts adjustments you make fool you into accepting your valuation with its glaring broad market assumptions inherent.

It is also imho hard to believe than the lone stock picker can spot a valuation error in a large cap share that 20 analysts have all missed, why do you believe any DIY Amazon valuation you or I do will be more accurate than the herd of analysts who make a living giving price guidance?

I am afraid I am a cynic, I believe individuals can rarely beat the valuation experts re large caps and when they do it is usually luck.

Good luck with your endeavours but do remember that whilst a DCF will spout out a value it will be very sensitive to discount rates , growth rates etc that you likely, somewhat arbitrarily, applied.

[OhNoNotimAgain]

Thank you very much for your response Charlottesquare that was very kind of you, i truly appreciate the time you took to leave a response.

I have ordered the book Samuels, Wilkes Bradshaw "Management Company Finance" it seems like this book could be helpful so i am very thankful for your recommendation on this. I would not have found this book so it was helpful you mentioned this was a core finance book regarding a degree in accountancy and finance in the 80s/90s.

Can i kindly please ask lastly for growth stocks like Amazon, if you believe for instance that the Amazon Web Services section of the business, was undervalued at current, and due to its large market share felt this would grow in the future. Alongside lots of other research in to the businesses financials and management, could you buy the stock without doing some of these realistic calculations like Discounted Cash Flow please? If you kindly had time to answer this i would be forever grateful and thankful for your support with this.

Thanks again for being a wonderful person Charlottesquare and for your very amazing help. Have a wonderful week and hope things continue to go well for you.

Sometimes analysts workings can be found for bigger companies, I would more spend time poring through these rather than trying a DIY approach from scratch. Also company briefings can sometimes be found online, whilst biased ,as company directors tend not to trash their own companies, information from these can also be useful.

You need to build a toolkit e.g. accounts, do you really understand them, do you understand what companies need to report, how they must record certain things, have you looked at the particular accounting standards they use, do you understand the raw components of debits and credits etc, working capital cycles etc.

Frankly I doubt I would ever buy Amazon direct, I avoid shares that are not UK listed (the only one I own is Berkshire) and would prefer any Amazon exposure via an IT that owns Amazon shares, accordingly I cannot make any comments re Amazon as have never studied it. Talking about Berkshire, reading Warren's views in his annual address to shareholders might be very valuable education as to "How to Think"

My opinion is that for those without a solid grounding in reading accounts etc DIY share analysis is maybe a waste of time, and even when you can read what they say any time you try to use the accounting figures to estimate value you also make some big and bold assumptions and the more of these you make the more unreliable your valuation. In addition all the numbers and tidy calculations can fool you into believing there is rigour when there is really a lot of estimates and assumptions.

For example company has reported EPS of £0.50, I think a P/E of 10 is appropriate so value at £5.00. Is my 10 reasonable? Well that depends on the Share's peers, growth prospects, how the market is pricing etc, so maybe 10 fine but maybe 8 or 15 are better. I am merely assuming 10 and that is a very significant assumption, is it justified? In fact it may well be a more significant error than digging in the accounts etc and finding the EPS stated is in any way overstated with the more realistic EPS being say 46p , the accounts being "optimistic"

Frankly digging in the accounts to nth degree but then assuming other non accounts factors seems to be precision coupled with waving a wet finger in the air, all the precise accounts adjustments you make fool you into accepting your valuation with its glaring broad market assumptions inherent.

It is also imho hard to believe than the lone stock picker can spot a valuation error in a large cap share that 20 analysts have all missed, why do you believe any DIY Amazon valuation you or I do will be more accurate than the herd of analysts who make a living giving price guidance?

I am afraid I am a cynic, I believe individuals can rarely beat the valuation experts re large caps and when they do it is usually luck.

Good luck with your endeavours but do remember that whilst a DCF will spout out a value it will be very sensitive to discount rates , growth rates etc that you likely, somewhat arbitrarily, applied.

An excellent post. Well said.

[doug2500]

A lot of sense spoken here, not overly positive on DCF though.

This time on The Investors Round Table Maynard Paton, Roland Head, Mark Simpson, and Bruce Packard discuss how they value companies, how they derive price targets and when to sell.

https://www.youtube.com/watch?v=3wXU0b_Zdd4

[XFool]

I wish you well with your investigation of DCF but it is not something I have any interest in, as I thought I had made clear. I once looked at it 25 years ago because it was very popular at the time (in the tech bubble) to explain the ridiculous valuations of companies that did not make any profit

How did you use DCF analyses on companies that did not make any profit? I'd have thought DCF analysis in such a case would, whatever the discount rate used, have given a company value of close to or zero. Which, in many case would in fact have proved pretty accurate.

I confess straight away I don't actually use DCF myself - I am far too indolent - but it has always struck me as ' a good idea'. After all, ultimately, what could the present 'value' of any company actually amount to or come from? I suppose it could also be worth whatever it could be sold for - but then again, the buyer would themselves have to value it somehow.

The usual way of explaining DCF is by an equation:

Present Value (PV) = sum of all discounted future cash flows (DCFs) + terminal value (however that is worked out)

This means, as is the way of equations, that the unknown variable (PV) is on the left and the known values (DCF) are on the right. Solving for the known values gives you the unknown, PV.

But hang on! The "known values", future cash flows and discount rate, are either unknown or just guesses. Whereas the "unknown" (PV) is already known! It is the market value, available whenever the market is open.

So, perhaps the best use of DCF in valuation is not so much to calculate the 'correct' PV as to start from the known PV and see what range of future cash flows for various discount rates can give that answer and then ask how likely or plausible these assumed future values (aka "the knowns") are.

Frankly, it doesn’t work, and the best thing I could possibly advise is that you spend time to better effect investigating other valuation techniques.

Why doesn't it work?

[TheMotorcycleBoy]

As several here remember when I "first became a private investor" (yes that was back in March 2018, my oh my, doesn't time fly!), I spent a long while on the holy grail looking for stock analysis tools.

DCF in theory would seem useful. However in practice it's flawed since it relies on guessimates of the 1) Discount rate, a figure whose precise formula is non-existent (IMO) and 2) the future growth rate(s) of the firms CFs.

These days, I try to just follow the market looking at 200d SMAs, and buying dips, after a quick catch up on the firm's recent reports and figures.

Matt

[Jam2Day]

As several here remember when I "first became a private investor" (yes that was back in March 2018, my oh my, doesn't time fly!), I spent a long while on the holy grail looking for stock analysis tools.

DCF in theory would seem useful. However in practice it's flawed since it relies on guessimates of the 1) Discount rate, a figure whose precise formula is non-existent (IMO) and 2) the future growth rate(s) of the firms CFs.

These days, I try to just follow the market looking at 200d SMAs, and buying dips, after a quick catch up on the firm's recent reports and figures.

Matt

...

[AndrewInDevon]

I can’t help chipping in on the difference between DCF and IRR….

A DCF is simply the present value (PV) of a future series of cashflows. To calculate it you need to assume a discount rate. In theory you set the discount rate at a level that equates to your “cost of funds”, which in a domestic setting might be the interest rate you get on your savings (assuming you are going to use savings to fund an investment) or on some other basis (eg you might borrow the money).

An IRR is the discount rate that equates to a net PV of nil. (ie. The PV of cash inflows minus the PV of cash outflows = NPV of nil). So in an investment setting the cash outflows are the sum you invest upfront and the cash inflows are the annual dividends. You should also assume a residual value of the investment at the end of your time horizon, ie the capital growth you would expect).

So DCF and IRR are both based on a discounted cash flow calculation, but they result in different outputs….one gives a PV ( based on an assumed discount rate), the other gives a discount rate that equates to NPV=0.

IRR is useful for investment decisions as you’d want it to exceed saving rates and compensate for risk of investments. That’s why many companies set a hurdle IRR in their investment decisions.

I use MIRR (modified IRR) as IRR does not assume annual returns are reinvested and this can materially understate the level of return, whereas MIRR does - it assumes annual returns are reinvested at the level of the discount rate).

[MDW1954]

"DCF" is simply the umbrella name for discounted cash flow analysis. It comes in two forms:

* Net Present Value (NPV), which is the sum of the discounted cash flows, and
* Internal Rate of Return (IRR), which is the rate of return at which the NPV is zero.

People get confused by IRR. Think about it as the investment's rate of return: in simple terms, that's all you need to know.

MDW1954 (MBA and PhD degrees covering this sort of stuff)