Friday, October 12, 2007
Discounted Cash Flow Valuation Of Stocks
A robust phenomenon exists in the minds of some individuals at present that profit must be attained regardless of cost. That is to say that no matter who you affect, or what devastation you bring, the ends justify the means provided there is profit. If you were to extrapolate this mentality to its fullest extent, these same individuals couldn't walk out the door of their house without being robbed, because everyone would have a right to what others had regardless of how they acquired it. Just ask those who ran Enron, when it was collapsing, how easily their bright candle blew out, to see that this type of behaviour is not sustainable, nor appreciated.
Profit is required to pay dividends, ensure long term growth in a company, provide for increases in compensation to employees and establish an indicator of success to the financial markets for inward investment. Another measure, which is external, is whether the company is a benefit to society.
One thing that the Financial Markets don't seem to pay as much attention to anymore is DCF, discounted cash flow, one of the methods used to show the true valuation of a company, and its potential to generate profit. If you asked Warren Buffett, who heads Berkshire Hathaway, about DCF he would probably say it was embedded in his financial philosophy.
Berkshire Hathaway invests in companies for the long term and watches them grow based upon their core market, their positioning, the strength of their management team, their long term future growth prospects, and finally their current profitability or even losses.
Using DCF, and estimating the discount rate, you can model the value of such companies by predicting the future year's cash flows (ten years usually) and calculate the sum of the present value of all cash flows (Income minus Expenses) in the overall period assuming a growth rate year by year. If you then add the current net assets minus the current net company debt from this you will have a final estimated company worth. Divide this final value by the total number of shares issued and compare this to the current stock trading price on a stock exchange. The variance between the estimate and the current trading price is one rationale of the degree of investment. There are also other factors like market perception that will either give a premium or a decrease in the DCF Valuation. You may also need to add in a continuity value beyond ten years, and discount this, if you are certain of the longevity of cash flows for the company. This DCF process is not absolutely accurate as it is an estimate but it does give a 'ballpark' comparison to the stock market traded price and is a tool in Corporate Finance.
At present, there is an element in the financial markets of trying to control the House at a casino of Life. Pricing manipulation tools not related to DCF are having an impact on valuation. There is too much greed for greed sake and in hyper-time. Gradually, the ability to sustain meaningful economic expansion in line with society demands, is being eroded because some would rather live just for themselves and not also for others.
One of the things that made one country grow in the recent past was that it worked to "secure the general welfare of the land", and this virtue is just as important to a company's solid growth foundation as it is to a country.