Discount Cash Flow Analysis
It is a fact that investors will not invest their money in stocks, which are more risky than U.S. Treasury notes, bills, and bonds, unless they are offered a required rate of return to “commensurate with the risk.” In order to calculate this risk and thus determine whether or not we should invest in a stock, we need to develop tools, which will allow us to calculate the current intrinsic value of a stock. Of course this is assuming that we wish to maximize our possible gains by buying low (undervalued stocks) and selling high (overvalued stocks). The mechanism that we will be using is referred to as the discount cash flow analysis mechanism. This mechanism makes it possible for us to produce a baseline valuation of almost any stock. A baseline value can be defined as an intrinsic value, or value at which the stock should be traded. Discount cash flow analysis is technique developed by Dr. J. Randall Woolridge, professor of finance at Penn State; Dr. Gary Gray, former manager director of a major Wall Street investment bank; and Dr. Patrick J. Cusatis, an associate professor of finance at Penn State and a Vice President of Tucker, Anthony & Co., an investment bank. Discount cash flow techniques are utilized by investment
bankers for merger and acquisition analysis, Wall Street traders to value debt obligations, and Wall Street analysts to value stock. Furthermore I will demonstrate how one can take advantage of the fact that market prices don’t always match the intrinsic value of a stock. I will explain exactly what a baseline value is and how we can use it to find a winning stock. Foremost I will outline the four steps used to calculate intrinsic value of a stock. Of course if our estimate indicates that our stock choice is undervalued we will buy it. The first step in this process is to forecast expected cash flow; then we must estimate the discount rate; thirdly we calculate the value of the corporation; and finally we will be able to compute our per share intrinsic stock value (value the market value tends towards). Before we begin our calculation, two main assumptions need to be assessed. All stocks in theory will constantly be moving towards their calculated intrinsic value. Next we need to assume that all values shown in a company’s balance sheet are accurate. Now we have intelligently negotiated our way to further explore our computation of the discount rate. The discount rate is also referred to as a corporation’s weighted average cost of capital (WACC), (Streetsmart Guide to Valuing a Stock). WACC is very similar to an investment portfolio’s weighted average return. Simply the weighted average can be calculated through the company’s several of obligations: debt, preferred stock, and common stock, thus returns both from dividends and appreciation associated with the stock. As can be easily drawn from the numbers below, Home Depots WAAC is 9.3. Again values needed to compute the WACC of a company can be found again on such websites as Yahoo Finance and America Online and other free websites. Shares Outstanding (mil) 2356 Company Beta 1.47 Tax Rate (%) 38.59 Short-Term Liab ($mil) 9309 Thus Home Depots expected rate of return is calculat
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Approximate Pages = 5 (250 words per page double spaced)
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