Intrinsic value of a stock using Discounted Cash flow Model

When you want to buy a stock at $1.70, are you sure it is really worth $1.70? You should have heard of Warren Buffets, who become a billionaire just by using value investing. You should have also heard that Warren Buffets always managed to buy company stock at a discounted value from its true value. BUT, how do you actually evaluate the true intrinsic value of a stock?

Net Present value (NPV)

Let me give you an example of how to find the intrinsic value of a stock:

You want to buy a cow, and this cow will produce $100 worth of milk every year for 10 years. At the End of 10 years, this cow can be sold for $1000. So how much you think this cow will worth? If your answer is $2000, then you definitely have to read on! Cause, you are WRONG!

To calculate its intrinsic value, you have to use the concept of Future and Present value of the money taking the inflation of money into account. Assuming the inflation of money is 5% per year.

Year	0	1	2	3	4	5	6	7	8	9	10
Future Value	0	100	100	100	100	100	100	100	100	100	100+1000
Present Value	0	95.2	90.7	86.4	82.3	78.4	74.6	71.1	67.7	64.5	61.4+613.9

The Net Present value (Sum of all Present value) = $1486.1.
Therefore, this cow only worth up to $1486.1 !!!!

The Formula is given by,

where t is time in years, PV(t) is Present value at time t, FV(t) is Future value at time t, r is the inflation rate.

To Calculate the Net Present Value (NPV),

Where, t is the time in years, NPV(t) is the Net Present Value at over the time t, PV(n) is the Present Value at time n.

Discounted Cash flow (DCF)

So now, you know how to find NPV. How does this relate to Cash flow?

Refer to the past 5-10 year of the annual report, look for the Operating Cash flow of the company. NOTE: If the growth of the operating cash flow is irregular or having more than 2 negative cash flow in a consecutive year then DCF can’t be used!

Estimate the growth rate of the company’s operating cash flow over 10 years.

Using the current fiscal year of the company’s operating cash flow as the initial value , calculate the future value ,FV(t), of the operating cash flow with the formula below,

where g is the estimated cash flow growth rate and t is the time in year. Note that the current year is t=0.

Using the projected FV(t) over 10 years, find the NPV of the cash flow. Finally the intrinsic value of the stock price can be found using,

Where P is the intrinsic value of stock, NPV is the Net Present value of the cash flow over 10 years, K is the number of outstanding common stock.

To read more about discounted cash flow and value investing, you can refer to the follow reference books. If you are a beginner to stock investing, I would strongly recommend you read the book “Secret of Millionaire Investors” by Adam Khoo and Conrad Alvin Lim.

Recommended Books