The discounted cash flow (DCF) method is a valuation technique used to determine the intrinsic value of a stock by discounting the expected future cash flows generated by the company. Here's a step-by-step guide on how to pick stocks using the DCF method:
- Research and select a suitable company: Begin by identifying companies that you are interested in investing in. Look for stable and well-established companies that have a consistent track record of generating cash flows.
- Analyze the company's financial statements: Review the company's financial statements, including the income statement, balance sheet, and cash flow statement. Look for trends in revenue growth, profitability, and cash flow generation.
- Estimate future cash flows: Forecast the company's future cash flows over a specific time period (usually 5-10 years). This should include projected revenue growth, operating expenses, taxes, and working capital requirements. Be realistic and conservative in your estimates.
- Determine the discount rate: The discount rate represents the desired rate of return you expect to earn from your investment. It takes into account the risk associated with the investment and the opportunity cost of investing in alternatives. The discount rate is usually determined using the company's cost of capital or a suitable benchmark rate.
- Calculate the present value of cash flows: Apply the discount rate to each year's projected cash flow and calculate the present value of each cash flow. This involves dividing the projected cash flow by the appropriate discount rate for that year.
- Calculate the terminal value: At the end of the projected time period, estimate the company's value beyond that period, often referred to as the terminal value. This can be done using various methods like the perpetuity growth method or multiple-based approaches.
- Sum up the present values: Add up the present values of the projected cash flows and the terminal value to arrive at the total present value.
- Deduct debt and add any other assets or liabilities: Adjust the total present value by the company's debt and add any additional assets or liabilities to arrive at an equity value.
- Divide equity value by the number of shares outstanding: Divide the equity value by the number of shares outstanding to determine the intrinsic value per share.
- Compare intrinsic value with the current stock price: Compare the calculated intrinsic value per share with the current market price of the stock. If the intrinsic value is higher than the market price, the stock may be undervalued and potentially worthy of investment.
It's important to note that the DCF method involves making several assumptions, and slight variations in these assumptions can significantly impact the calculated intrinsic value. Therefore, it's crucial to apply the DCF method alongside other fundamental and qualitative analysis techniques to make informed investment decisions.