Estimating Future Cash Flow

The main idea behind a discounted cash flow (DCF) model is relatively simple: A stock's worth is equal to the present value of all its estimated future cash flows. Putting this idea into practice is where the difficulty lies.

Where to start

The first step to valuing any stock with a DCF model is estimating the future cash flows the underlying company is going to generate. Many variables go into estimating those cash flows, but among the most important are the company's future sales growth and profit margins. Projecting such variables doesn't involve simply extrapolating present trends into the future. In fact, doing so can often lead you to believe a stock is worth a lot more (or less) than it really is.

When predicting a company's revenue growth, it's important to consider a variety of factors, including industry trends, economic data, and a company's competitive advantages. A company with strong competitive advantages (known as a "wide economic moat") may grow faster than its competitors if it is stealing market share. Paying attention to a firm's customers is also important. For example, if GM (GM) or Ford says it will produce fewer cars over the next couple of years, it would be wise to check your revenue growth assumptions for auto parts suppliers.

Determining a company's future operating profits entails similar detective work. Looking into a company's costs is an obvious first step. Chemical companies heavily reliant on oil and natural gas, for example, could see profit margins contract if these materials go up in price and they cannot pass these cost increases on to customers.

Some important things to consider

On the other hand, some companies benefit from operating leverage. Operating leverage means that as a company grows larger, it is able to spread its fixed costs across a broader base of production. As a result, the company's operating profits should grow at a faster rate than revenue. Think back to eBay (EBAY). It can add thousands of customers with only very modest investments to its existing computer systems. Likewise, a software company sees most of its costs in development. Adding an additional customer doesn't change this key cost.

One question that must be asked of any discounted cash-flow model is what kind of cash flows you are going to be discounting. In the old days, investors used something similar to a dividend discount model, which essentially sums up all the future dividend payments a company is expected to make and expresses them in terms of today's dollars. However, discounting dividends is of little help for valuing companies that pay no dividends, which includes many firms today. Rather, most DCF models nowadays use some form of cash flow, or reported earnings with noncash charges excluded. The DCF model that we will talk about here discounts free cash flow, which is defined as operating cash flow minus capital expenditures.

Free cash flow represents the cash a company has left over after spending the money necessary to keep the company growing at its current rate. It's important to estimate how much the company reinvests in itself each year via capital expenditures. Reinvestment can take the form of a company purchasing machinery to start up a new production line, or retail companies opening new stores to expand their reach.