How to use discounted cash-flow

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Discounted cash-flow (DCF) is a common way of valuing companies, often used by analysts as a basis for setting the target prices that have become a common feature of broker notes in recent years. It is, however, far from infallible.

The technique involves forecasting free cash-flow for a period of years into the future and applying a discount factor to each year's figure to reflect the expected time until it accrues. The further in the future, the greater is the discount applied to that year's free cash-flow.

The discounted cash-flows for each of the future years are then added together. An additional value is placed on the total cash expected to accrue in perpetuity beyond that. The total of these two items is compared with the current market value of a company to see if its shares are cheap or expensive. When analysts perform these calculations they nearly always, surprisingly, show that the shares are cheap.

Free cash-flow is, effect, operating profit after tax and interest paid, but ignoring book-entry transactions. So it ignores depreciation, amortisation of goodwill, retained profits of minority owned companies, capitalised interest and any other items that are merely the result of accounting devices.

As well as knocking off interest and tax paid from the resulting figure, allowance is often also made for sufficient capital spending to maintain its fixed assets. A DCF calculation requires making predictions of cash-flows for the next 10 years, and then assuming a growth rate in subsequent years too.

Discounting involves reducing each successive year's cash-flow reduced by an amount (the discount factor) reflecting the compounded discount rate. The discount factor reflects both investors' preference for cash sooner rather than later, and the greater uncertainty (and vulnerability to subsequent inflation) surrounding cash received in the future. These calculations can normally be done easily on a spreadsheet, but the discount rate is applied uniformly over time, its impact in each successive year increasing to reflect the effect of compounding.

The choice of discount rate is a vexed question.

As a minimum the discount rate should be the risk-free rate of return on 10-year money - reflecting that cash-flows are usually predicted and discounted for up to 10 years ahead. In normal times, the discount rate might, for example, take as its basis the redemption yield on a 10-year government bond. It is normal, however, to add an equity risk premium to this number, the size of the premium based in part on the underlying volatility of the shares in question.

Attempts to cloak this process in some sort of scientific method are often made, but the reality is that forecasting cash-flow for a company for the next 10 years is at best approximate. A reasonable stab might be made for the current financial year and the one following, but after that it gets progressively more difficult to arrive at a precise figure. All one can perhaps say is that cash-flow is a better yardstick to use for valuing a company than profit, which is capable of easy manipulation and smoothing.

Using a market driven return, like the yield on a 10-year bond, as the basis for a discount rate is also theoretically a sound idea, but the problem is that with quantitative easing, 'operation twist' and other devices currently in play, the basis for the discount rate is actually a rigged market.

Because lowering a discount rate automatically increases the value of discounted cash-flows, plugging 10-year gilt yields into DCF models in the current climate is likely simply to show company values so unrealistically high as to be a meaningless guide to the course of future share prices.

It would arguably be better to base a discount rate on, say, the RPI plus 1%, rather than use yields that imply abnormally high negative real interest rates. Inflation is one of the reasons behind the so-called 'time value of money' which drives the concept of discounting in the first place.

Nonetheless, discounted cash-flow is a long established technique originally developed for use by companies assessing capital investment projects. Get a company to tell you the rate it uses for valuing projects internally and you have a good guide to the rate to use to value the shares. The problem is that this information is not readily available.

The beauty of DCF models is, however, that the figures and assumptions in them can be updated when, for example, new annual accounts are issued, when bond yields or inflation rates change, and when other new information comes to light.