What long term investors commonly look for is discounted stock cash flow. This may sound a bit complicated but it goes to the heart of long term investing. Discounted stock cash flow is basic to one of the two pillars of long intrinsic stock value. What is intrinsic stock value? It is the current value of a stock when one considers the future income that owning the stock will produce. Calculations of intrinsic value must take into consideration the return on investment at one could receive from US Treasuries, an essentially risk free investment, and the corrosive effects of inflation on the US dollar. Discounted cash flow is a financial term so let us look first at a strict definition of the term.
Discounted Stock Cash Flow
This is a means of assigning a value to a stock but also a project or a whole business considering the time value of money. One estimates future cash flow in its entirety as well as future interest rates and inflation. Inflation is not strictly part of the equation if one is comparing value in future dollars. However, some investments perform much better in terms of being inflation hedges so many long term investors add inflation to their calculations. The end result of a discounted cash flow calculation is a fair price for a stock considering its calculated future prospects. Obviously, if the discounted cash flow of a stock results in assigning a higher price to the stock that it currently sells it the stock is a good buy. These calculations differ from finding the margin of safety of a stock which has to do with those aspects of a stock that protect against bankruptcy in dire economic times.
Where Is This Tool Best Used?
Discounted stock cash flow is a good tool for picking growth stocks. The question can be posed, how much money do I have to put in a secure investment such as a ten year or thirty year Treasury bill in order to have as much money as a given stock will be worth in given number of years? A stock that does not pay dividends and merely appreciates in value makes the calculation easier. Dividend stocks can be great long term investments but one needs to consider the tax consequences of each dividend payment along the way.
What Are the Pitfalls of Using Discounted Cash Flow?
Estimates, estimates, and estimates are the problem with projecting the future cash flow and therefore the future value of a stock. The best way to approach calculation of discounted stock cash flow is to do the calculation several times using a range of probable numbers. Interest rates may vary so do the calculation with a range of rates. Company cash flow may grow, or fall, at varying rates so use a range of average growth figures. This approach will allow the conservative investor to appreciate the range of possibilities of purchasing a stock. Smart investors demand a risk premium. That is to say the investor could just as well put his money in US Treasures and sleep well at night. He expects to be paid for taking a risk on any stock which could fall in value or even go into bankruptcy. Many simply calculate the risk free rate and multiply by a “premium factor” to determine what they want in discounted stock cash flow. If the stock meets the criteria they buy and if not they pass. This method is a basic tool of fundamental analysis of stocks.