Discounted Cash Flow is a way of estimating the current value of an investment in today’s dollars based on assumptions of  future growth of cash flows discounted back to the present. This is a vital concept to understand for valuing long term investments, not just in stocks but Real estate, businesses, etc. Once you have determined the value for an investment you compare it to the current price to help you decide whether it is worth investing in. One can easily mislead oneself with the incorrect use of DCF. Too conservative inputs and you will miss opportunity, too liberal and you will get stung by an overvalued company. More about this later.

Yes DCF is a little complicated. First you need to start with  Free Cash Flow (FCF). The idea is to calculate what future cash flows will be in a specified time. The way this is often done is to base it on past free cash flow growth. I look at the last ten years to smooth out inconsistencies to calculate a rate. In my DCF spreadsheet I usually this for the first year or two and then begin to reduce this rate  gradually until I get to ten years. That is when it reaches the terminal rate, or the rate at which you think it will grow indefinitely. The terminal rate is often set at 3% but can be adjusted lower or higher depending on the industry and the circumstances. Finally, when you estimate out as far as you are interested in calculating (20 years or 10 years are common time frames) you need to discount it back to the present. The discount rate more many investors will be the Weighted Average Cost of Capital (WACC). I don’t use it, mostly because it is too complicated and likely to be smaller than desired rate of return . Another way to look at the discount rate is the question how much do I want to make each year on my investment. I always want the classic amount Warren Buffett used to say he wanted from to earn from his investments or 15%.

The DCF is a very common source of instrinsic value for value investors, but it does have some serious limitations that you must be aware of. The success of the equation is dependent on getting the inputs correctly. Fairly modest errors of input can result in catestrophically incorrect valuations. That is why, as with everything, we go back to Ben Graham’s concept of Margin of Safety. Once you have determined the instrinsic value of a company is, you should allow for a margin of saftety that helps offset errors of input. I use 50% for almost every company, but occasionally I will dip down to 33% for a truly blue chip stock, but not often.

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