Financial ratios and multiples provide a quick and easy way for investors to determine the general value of a stock compared to other investments in the market. The first question that comes in to the heads of many investors before planning to invest is “What is this company worth?”. This can be answered by talking about 2 primary valuation methodologies:
- Intrinsic Value (discounted cash flow valuation)
- Relative Valuation (comparable/ multiples valuation)
INTRINSIC VALUE (DISCOUNTED CASH FLOW VALUATION):
Valuation methods based on discounted cash flow model is determine stock prices in a different and more robust way. DCF models estimate what the entire company is worth. Comparing this estimate, or “intrinsic value”, with the stock’s current market price allows for much more of an apples-to-apples comparison. For example, if you estimate a stock is worth 20 rupees on a DCF model and it is currently trading at 10 rupees, the stock is undervalued.
- The DCF approach says that the value of a productive asset equals the present value of its cash flows.
- The discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value estimate, which is used to evaluate the potential for investment.
- If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
- The time value of money is the assumption that a dollar today is worth more than a dollar tomorrow.
There are actually two types of DCF models: “free cash flow to equity” and “cash flow to the firm”. The “free cash flow to equity” method involves counting just the cash flow available to shareholders, where as “cash flow to the firm” involves counting the cash flow available to both debt and equity holders.