Warren Buffet believes the only way to value companies and their shares is by the DCF (Discounted Cash Flow) method.
At its simplest he argues that the calculation of how much cash a share is going to return back to you over time is the way you should use to decide whether a share is worth buying now or not. This involves adding up the current value of future expected cash flows generated by the company and comparing this figure with the current value of the company in the stock market.
Let’s take a look at discounted cash flow and see what exactly Buffet (and others) are looking for and mean.
Discounted cash flow/Net Present Value
This method of valuation was originally devised to allow companies assess proposed capital investment projects. The starting point to understanding this method is to note that the value of money in the future is less than the value now and must be discounted.
In other words, €5,000 in your hand now is worth more in real terms than €5,000 at the end of the year or in 3 or 5 years’ time. Let’s face it, a sum of money in the hand now is worth more to you than the same sum of money in a year’s time or later.
With respect to valuing a company or its share price you adjust downwards, or discount, cash flow in each succeeding year in the future. This discounting is to take inflation and uncertainty into account.
So, you must project the future cash flows and discount them to give them a value today.
At the end of the calculation the discounted values of all future cash flows are totalled and compared with the current market value of the company.
What discount rate should be applied, however? This can range from the yield on a government bond to a higher rate of discount for a company in a riskier range of activities.
The more volatile a share price the greater degree of discount you would apply. You can add a notional risk premium to a share and multiply this by a share’s bet factor-that is, the amount by which a share has statistically tended to move for a given percentage movement in the market. You then add this figure to the risk-free rate (government bond yield) and use that as your discount factor.
This method of valuation allows you to arrive at a value for a share and you simply compare this with the current share price and decide whether to invest or not.
Spreadsheets and calculators
You will find spreadsheets such as Microsoft XL and Google Sheets contain NPV formulas as standard. You will also find DCF and NPV calculators online with a simple Google search.
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