So previously we talked about the dividend discount model and that was how we would value the firm as a stream of dividends into the future and we would take the present value and discount those dividends to the present. Then there was the total payout model, where we looked at both dividends and share repurchases. Now with the discounted cash flow model which we sometimes abbreviate as DCF, we’re not going to concern ourselves with dividends or share re-purchases what we’re concerned with is free cash flow.
The Discounted Cash Flow Model model:
So our share price is going to be a function of the present value of free cash flow + cash – debt and then we divide all of that by the number of shares outstanding.
Free Cash Flow:
So if you’re wondering what this free cash flow is, I’ll just give you a quick review. Free cash flow is [Earnings before interest in taxes multiplied by (1 minus the tax rate)] we take that and then we add depreciation subtract capital expenditures and then subtract the increase in net working capital. So if that’s a little complex for you or you haven’t seen that before I encourage you to check out the article I have on free cash flows but for right now let’s just focus on an example and we’re going to apply this DCF model that we’ve built right here to an actual firm.
Example of Discounted Cash Flow Model model
So let’s say you’re thinking of investing in a firm and you have the following numbers you have the following data
The free cash flow for the firm is $90,000.
The firm has $15,000 cash currently in its bank account.
It has $40,000 in debt and there are 50,000 outstanding shares for the firm.
The growth rate of your free cash flow is 5%.
The weighted average cost of capital is 12%.
So now let’s just let’s go ahead and start putting our model together here. First off is we’re going to have in our numerator we’re going to have that $90,000 free cash flow and then we need to discount that. So we’re going to discount it we’re going to have the 12% WACC and then we’re going to subtract out our growth rate that’s 5%. Now we’re going to add in that cash that $15,000 cash and then we’re going to subtract out the $40,000 in debt. Then in our denominator, we’re going to have the number of shares outstanding. Now I’m just going to break down the math a little bit here and there’s a little bit of rounding so if we don’t get the same exact number don’t worry about it. 1,285,714 + 15,000 – 40,000 all over 50,000 try not to skip any steps here. Then that’s going to equal twenty-five dollars and twenty-one cents.
So is our share price for this firm that we just valued is $25.21 and the advantage of the dividend discount model over the total payout model is that we were able to value the firm without considering dividends or share repurchases.