This post includes an important topic of stock valuation. And the topic is Discounted Cash Flow Method or DCF Method. Dcf valuation helps to find the intrinsic value of stocks. Dcf valuation method is a very popular method of valuation. The concept of dcf or dcf valuation formula is very simple. To understand discounted cash flow or dcf valuation formula you should know about free cash flow and how to calculate free cash flow of any stocks?
Free cash flow means the company’s cash except total expenditure. This is the cash flow that remain after the total expend,tax of the company. For this it is called free cash flow. Company can use this cash for any work like company can acquire,expand,give dividend to its shareholder,share buy back etc. Let’s see how to calculate free cash flow.
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Free cash flow formula:
Free cash flow= operating cash flow- capital expenditures.
Think net cash provided by operating activities of ‘Y’ company is 25067 crore and purchase of fixed assets is 1862 crore. Then
Free cash flow
= operating cash flow – capital expenditures
= net cash provided by operating activities – purchases of fixed assets
= (25067-1862) crore
= 23205 crore.
Now the question is what is the difference between net profit and free cash flow? After cutting expenses,interest,taxes,depreciating and amortisation we get net profit. If net profit of any company is 100 crore then it is not right that company has 100 crore cash. It has many reasons like accrual account method, non cash expenses etc. Revenue in financial statement in accrual account method is recorded when the transaction is completed but not recorded when company get the money for the transaction. So in accrual account method revenue is recorded on the basis of transaction not the basis of cash.
Net profit is an initial point. The real game is on the hand of cash flow statement. Because company’s real movement can be seen in cash flow statement because here you can see how much money come to the company and out from company. And the important point is that it is impossible to manipulate cash flow statement because assumption have no place in cash flow statement. Now after free cash flow understand dcf valuation or discounted cash flow valuation method.
To calculate the intrinsic value of stock using dcf valuation or dcf stock valuation formula you have to need 3 things.
- First: Analyzing the growth of company you have to predict the incresing rate of free cash flow in future years.
- Second: Terminal growth rate or growth rate after 10 years.
- Third: Discount rate.
The difficult and important thing in dcf stock valuation formula is to predict future cash flow. You can do it easily with the help of common sense and reasonable analysis. If you predict the future growth on the basis of past performance or growth then you can face problems. Always remember use common sense and reasonable analysis. To predict free cash flow of any company you should need to be deep knowledge of this company.
Dcf example :
calculate valuation using dcf valuation method of a tyre company you have need at first future cash flow and growth rate. To predict this you should need to be the knowledge of rubber company and who is the end user of this product? For which car company make tyre? And the other company which make the tyre for same car. And also you should check about the extra advantage that helps to rank first with the competition of same industry’s company. And using common sense predict the cash flow growth rate. If you approximately predict the growth rate then dcf stock valuation can not help you.
Best wishes to invest.
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