what a DCF is
A DCF is basically a fixed income valuation technique. The simplest case is a government bond that pays a fixed interest rate, with interest paid once a year in arrears. The rate is set at the time of purchase. Buying one now, you’d give the government $1000, in return for which you’ll get a payment of $42.20 at the end of each year until in year 10 you’ll get not only the interest payment but also your $1000 back.
If rates don’t change over the ten years, the final payment would be worth about $660 today and the present value of the interest payments would amount to the other $340.–although in dollars of the day as they were paid, they’d be worth $422.00.
If, on the other hand, rates rise to 7% the day after you commit and stay there for the next decade, the present value of the final payment drops to just over $500–and you’ve lost a bunch of money. On the other hand, if rates drop to 2% and remain there, the final payment spikes to $820, and you’re up considerably.
using DCFs with stocks
The argument for doing so is that the sum of the present value of all the projected future cash flows for a given publicly-traded company is pretty much like the payments you’d get by buying a bond. You could also make a more elaborate spreadsheet, in which you examine the effect on a DCF of different interest rate scenarios for different economic environments. You can “age” a company by having cash flows to reflect vigorous earnings-rich youth, followed by a more sedate middle age where results move in line with overall GDP growth. And you can “kill” the company by putting in zeros after a certain date.
You can also do similar calculations for, say, the S&P 500 as a whole, and use that to create a relative value matrix of potential stock market winners and losers, rather than absolute results. This would hopefully hedge against the possibility that your overall economic growth expectations prove way off the mark.
Life isn’t this simple, though.
More tomorrow