There are two primary ways in which investors analyse stocks: technical and fundamental analysis. Technical analysis helps the investor determine the best to time to invest in a security or project, whereas fundamental analysis helps investors determine what to buy. One of the most common valuation measures used in fundamental analysis is discounted cash flow, which looks at the present value of future cash flows.
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Things you need
- Excel spreadsheet
Forecast a company's net income and depreciation expense projected over five years. If you do not know how to forecast, assume a 5 per cent growth rate and apply it to the current year's net income and depreciation during the next five years. For instance, if net income is £65,000 and depreciation expense is currently £3,250, you can multiply both amounts by 1 + 'the growth rate' for the following year's forecast. The calculation is £65,000 x 1.05 = £68,250; £3,250 x 1.05 = £3,412. Now apply a growth rate to these numbers for the second year of forecasts.
Calculate future cash flows for the business. Subtract the projected depreciation expense from net income for free cash flow.
Determine the discount rate. The discount rate is the average cost of capital for the company. Let's say the average cost of capital (both debt and equity) is 10 per cent.
Find the terminal value. Divide the last-year forecast by the discount rate to determine the terminal value.
Use the net present value function in Excel to find the discounted cash flow value. Open an instance of Excel and input the future value of cash flows in cells A1 through A5. In cell A6 input the following formula to calculate DCF: "=NPV(10,A1,A2, ...A5)", where 10 is the discount rate and A1 through A5 are the future cash flows.
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