Imagine the scenario where you decide to invest a specific portion of your pocket money say Rs1000 into stocks. Well, how would you select the appropriate stock? Will you blindly follow the advice given by your friends and family, or would you, as an intelligent investor, do a cost-benefit analysis?
For people belonging to the second category, Discounted Cash Flow (DCF) Analysis comes to the rescue.
What is the DCF Analysis?
Merely stating, DCF Analysis is a process that calculates the value of an investment based on forecasts of how much money the investment is going to make in the future.
Say, for example, now you have an option to receive Rs 1000 now or Rs 1000 one year down the line. What will you choose? Obviously, you would prefer receiving Rs 1000 now so that you can invest Rs 1000 and earn more than Rs 1000 in one year's time.
Significance of DCF Analysis
Now, if you apply the above calculation for all the cash, you expect from your investments in the future and discount it to arrive at the Net Present Value, which is the Present Value of Cash Inflows less the Present Value of Cash Outflows. This Net Present Value is the intrinsic value of the stock. But hey! Don't confuse this intrinsic value with the market value of the stock. We will talk more about intrinsic value later.
What is the Discount Rate?
Discount Rate can vary according to the type of cash flows that we intend to discount. For instance, to assess the viability of ay project, a firm uses Weighted Average Cost of Capital (WACC) as the discount rate. However, to keep things simple, hereby discount rate we mean the required rate of return we expect on our investments.
Importance of DCF Analysis in Equity Valuation.
Well, DCF Analysis comes in handy while calculating the term "Intrinsic Value," which we mentioned earlier and which is also an essential factor while undertaking the stock purchase. As already mentioned, intrinsic value is the value of the stock's cash flows discounted by the required rate of return. However, keep in mind that it is different from the market value, which is the total value of the firm's outstanding shares multiplied by the price at which it is trading on the bourses. You must be wondering that why do we need to know the intrinsic value?
This is because it determines whether the stock is overvalued or undervalued, i.e., whether the stock is overpriced or underpriced. How can you decide that? Just keep in mind these two simple rules:
In the case of underpriced stock, you can certainly opt for buying the security, whereas in the case of overpriced stock, you should avoid buying the security.
What happens if you, as a company, are looking forward to the funding of your new project? If you try and approach any investor, he/she would first look forward to the Net Present Value (NPV) of your project.
If NPV is positive, the investment would be profitable otherwise not. This NPV is arrived using the DCF Analysis through a detailed financial model.
Criticisms of DCF Analysis
The discount rate used in DCF Analysis is based solely on assumptions. What if the assumptions go wrong? The results generated will definitely be inaccurate.It is useful to use DCF Analysis only when the cash flows can be known with certainty. Inaccuracy in cash flow calculations will generate inaccurate results.
Nevertheless, DCF Analysis is and will remain one of the most popular techniques while undertaking the fundamental analysis.