The Formula For Equity In A Combined Margin Account Is Discounted Cash Flow – How Much is a Stock Really Worth?

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Discounted Cash Flow – How Much is a Stock Really Worth?

The basic idea of ​​the discounted cash flow model is relatively simple – the value of a stock equals the present value of all its estimated future cash flows. This estimate is also called the company’s “intrinsic value” – its true intrinsic value.

If a stock is trading below its value, you’re in for a bargain!

A discounted cash flow model can become quite complex when you introduce several additional variables to predict future cash flows. We use a simpler version of this model to calculate intrinsic values ​​and make stock purchase decisions.

If that sounds like a mouthful of financial talk, don’t sweat it. Let’s break it down into elements….

  • Estimation of future free cash flows
    Free cash flow is the money a company has left over after it has spent the money it needs to grow at its current rate. In other words, Free Cash Flow = Operating Cash Flow – Capital Expenditures To forecast free cash flow, we need to have an idea of ​​how the company is going to grow – in terms of sales, revenue and expenses. Examining the company’s financial statements over the last few years and our own understanding of how the company is doing should give us an idea of ​​these numbers – our best guess.
  • Discounting future free cash flows

    What are those future cash flows today? A dollar today is worth more than a dollar ten years from now. So we need to “discount” these future cash flows to their present value (PV). The formula for calculating this is: CF PV in year N = CF in year N / (1+R)N where CF = cash flow R = discount rate N = number of years in the future discount also called cost of capital. This is really the interest rate that the company would have to pay if it had to raise capital from investors. Rate is dictated by risk – a stable, predictable business has a low cost of capital, while a risky business with unpredictable cash flows has a higher cost of capital.

  • Permanent value
    How many years into the future are we calculating free cash flow? We usually stop after a certain number of years – usually 10. Beyond that, we aggregate all future cash flows into a number called “life value”. The formula is: Constant value = [CFn x (1+ g) ] / (R – g) where CFn = cash flow in the last single estimated year (usually 10 years) g = long-term growth rate – usually estimated at 3% R = discount rate This persistence value must be discounted to this value. Perpetual Value PV PV = (perpetual value)/(1+R)Nwhere R = discount rate N = number of years in the future
  • Putting it all together
    By adding the discounted free cash flow projections for our chosen period (10 years) and the discounted fixed value, we get the “intrinsic value” of the company. Divide this by the number of shares outstanding and … voila … we have a stock price estimate!

How good is this stock price forecast?

How accurate is this number? It’s really a valuation based on our prediction that the company will grow and how future values ​​are discounted to today’s value. Therefore, we use this number only as a ballpark. We must always build in a safety margin to protect us from assumptions that may turn out to be wrong.

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