Kirk's Market Thoughts: Discount cash flow analysis

» KirkL - Discount cash flow analysis

Discount cash flow analysis

GG, I can try to explain, but I have never done one and then shown it to an expert to verify that I did it right so take that into consideration….

• What you do is make a spreadsheet with one column as earnings by quarter going out to infinity. Here is where you show earnings growth which could be high now but should lower as a company gets larger as it eventually gets hard to grow earnings at a high rate.
  
• Then next column might be inflation between today and that quarter (you can write a formula for this if you assume a typical inflation rate, but you could also make that a quarterly column and then work backwards to get the result).
  
• Then you have an annual discount factor in the next column perhaps getting larger as you go out in time to reflect lower visibility and thus higher risk.
  
• now you take the earnings by quarter and and estimate the present value of those earnings assuming they are lowered by the discount factor and use the total inflation to the earnings flow date. This is the final column entry.
  
• Now sum the last column from now until infinity.
  

IF your assumptions are reasonable, then the last column should get close to zero contribution and you won't need to sum to infinity but maybe 5 to 30 yrs. to capture 99% of a stocks present value. This is what the stock should sell for today.

What is really interesting is if you don't use a discount factor, then the number goes to infinity any time the stock grows faster than inflation. This easily explains why people buy growth stocks too… It also explains why a stock gets hammered when it first misses earnings as the lower then expected growth gets projected out to infinity and then lowers the present value of a stock.

Some will say, "But Dell, or IBM or AOL made its earnings estimate and still got hammered" and I would say that was because revenue growth or future visibility might have been lowered as there is more to a stock's price than earnings. With people giving $400 rebates to use their ISP for 3 yrs, you can see that AOL's future revenue from this source is now in jeopardy and so you might raise the discount factor and/or future earnings estimates.

Anyway, it is an interesting thing to go through once just for your own education. Perhaps do a projection for the S&P500 where you assume an 8% earnings growth rate, 2 % inflation and a constant discount factor. Iterate with the discount factor until you get a sum that gives today's S&P500 price. Now use this discount factor and change growth rates from 8% to 9% or even 15%…. Once you have "your model" you can see how changing inflation or earnings growth will effect the overall stock market.
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-- posted by KirkL