While the concept behind discounted cash flow analysis is simple, its practical application can be a different matter. The premise of the discounted cash flow method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders.
Its calculation is as follows:
For simplicity’s sake, if we know that a company will generate $1 per share in cash flow for shareholders every year into the future; we can calculate what this type of cash flow is worth today. This value is then compared to the current value of the company to determine whether the company is a good investment, based on it being undervalued or overvalued.
There are several different techniques within the discounted cash flow realm of valuation, essentially differing on what type of cash flow is used in the analysis. The dividend discount model focuses on the dividends the company pays to shareholders, while the cash flow model looks at the cash that can be paid to shareholders after all expenses, reinvestments and debt repayments have been made. But conceptually they are the same, as it is the present value of these streams that are taken into consideration.
As we mentioned before, the difficulty lies in the implementation of the model as there are a considerable amount of estimates and assumptions that go into the model. As you can imagine, forecasting the revenue and expenses for a firm five or 10 years into the future can be considerably difficult. Nevertheless, DCF is a valuable tool used by both analysts and everyday investors to estimate a company’s value.
Financial ratios are mathematical calculations using figures mainly from the financial statements, and they are used to gain an idea of a company’s valuation and financial performance. Some of the most well-known valuation ratios are price-to-earnings and price-to-book. Each valuation ratio uses different measures in its calculations. For example, price-to-book compares the price per share to the company’s book value.
The calculations produced by the valuation ratios are used to gain some understanding of the company’s value. The ratios are compared on an absolute basis, in which there are threshold values. For example, in price-to-book, companies trading below ‘1’ are considered undervalued. Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.