|
Company
accounts analysis
|
|
|
Discounted cash flow analysis
 |
City analysts typically consider discounted cash flow (DCF) analysis more important than other methods of analysis. It translates
a company's future cash flows into present value.
For more about how DCF analysis works in the context of cash flow generally, look now at this article I contributed to InvestorsWorld.
|
Work it out for yourself
On this web page, you can learn to conduct your own DCF analysis. First, find the net operating cash flow (NOCF). You will do this by taking the underlying company's earnings before interest and tax (EBIT).
Deduct corporation tax paid and capital expenditure. Add depreciation
and amortisation, which do not represent movements of cash. Add or subtract
the change in working capital, including movements in stock, in debtors and
creditors, and in cash or cash equivalents.
This is the year's NOCF. You should calculate it also for future years, reduced in value to present day terms by a discount rate broadly representing inflation in reverse. Also, cash flow will continue infinitely beyond the period over which the future cash flows are spread. This is the terminal value.
Net present value
Present and future cash flows, together with the terminal value, make up the net present value. Its accuracy depends partly on the future NOCF forecasts, and the number of years used. Also, the larger the discount rate used, the smaller is the net present value of future cash flows.
The discount rate used by analysts is normally the company's weighted average cost of capital. This represents the cost of capital to the company weighted by debt and equity. This is split into its two parts. The cost of debt is the yield to maturity on the company's bonds. The cost of equity is
typically measured by the Capital Asset Pricing Model.
The capital asset pricing model
The CAPM is widely used but controversial. It assumes that investors should be rewarded for acquiring investments which carry a larger amount of "market" risk that cannot be diversified away. This risk is measured by beta, which is a historical figure, and so unreliable.
Given the uncertainties, analysts may plot DCF models using different discount rates to present alternative valuations. Although, some abuse the method to paint an over-optimistic picture of a favoured company, DCF analysis is the most realistic method of valuation available.
More about cash flow
For details of cash flow-related ratios, click
here.
For a description of the cash flow statement, click
here.
|
Click the button below to access an
|
Why not get to grips with DCF analysis in more depth? Read How to Win in a Volatile Stock Market by Alexander Davidson. There is a chapter on the subject that explains the concept clearly, and in more detail than here.
|
