using a discounted cash flow technique to value stocks

Forecast Expected Cash Flow:

the first order of business is to forecast the expected cash flow for the company based on assumptions regarding the company's revenue growth rate, net operating profit margin, income tax rate, fixed investment requirement, and incremental working capital requirement.

Estimate the Discount Rate:

the next order of business is to estimate the company's weighted average cost of capital (WACC), which is the discount rate that's used in the valuation process.

Calculate the Value of the Corporation:

the company's WACC is then used to discount the expected cash flows during the Excess Return Period to get the corporation's Cash Flow from Operations. We also use the WACC to calculate the company's Residual Value. To that we add the value of Short-Term Assets on hand to get the Corporate Value.

Calculate Intrinsic Stock Value:

we then subtract the values of the company's liabilities—debt, preferred stock, and other short-term liabilities to get Value to Common Equity, divide that amount by the amount of stock outstanding to get the per share intrinsic stock value.

so how does a corporation make money? It makes money by operating business lines where it manufactures products or provides services. A company generates revenue by selling its products and services to another party. In generating revenue, a company incurs expenses—salaries, cost of goods sold (CGS), selling and general administrative expenses (SGA), research and development (R&D). The difference between operating revenue and operating expense is Operating Income or Net Operating Profit.

To produce revenue a firm not only incurs operating expenses, but it also must invest money in real estate, buildings and equipment, and in working capital to support its business activities. Also, the corporation must pay income taxes on its earnings. The amount of cash that's left over after the payment of these investments and taxes is known as Free Cash Flow to the Firm (FCFF).

FCFF is an important measure to stockholders. This is the cash that is left over after the payment of all cash expenses and operating investment required by the firm. It is the hard cash that is available to pay the company's various claim holders, especially the good guys—the stockholders! The simple equation used to calculate FCFF is:

FCFF = NOP – Taxes – Net Investment – Net Change in Working Capital

there are five key cash flow measures that are important in estimating the free cash flow to the firm that is used in the DCF approach. Those five cash flow measures are as follows: the revenue growth rate, the net operating profit margin, the company's income tax rate, net fixed capital investment rate, and incremental working capital investment rate.

The revenue growth rate is equal to your estimate of the firm's revenue growth rate in percent over the Excess Return Period.

Net operating profit margin is equal to a firm's operating profits divided by its revenues. A firm's income tax rate is equal to the provision for income taxes divided by the firm's operating income before provision for taxes. The information necessary to compute NOPM and income tax rate can be found on the firm's income statement as part of its annual or quarterly reports.

Net fixed investment rate is equal to the company's new investment in plant, property and equipment (PP&E) minus depreciation charges taken. To calculate this ratio, you need to know the company's investment rate, equal to the firm's yearly investment in PP&E divided by revenues, and the company's depreciation rate, equal to the firm's depreciation charges divided by revenues. The firm's investment in PP&L and depreciation charges can be found on its cash flow statement in its annual report.

Incremental working capital investment rate is equal to the change in working capital divided by the change in revenue. Working capital is equal to [( Accounts Receivable + Inventory) – Accounts Payable]. The firm's accounts payable, inventories, and accounts receivable can be found on its annual balance shehe free cash flow to the firm approach provides for several distinct time periods for estimating cash flow which allow differing value-creating periods for a corporation's business strategy. In the Excess Return Period, because of a competitive advantage that the firm has, the corporation is able to earn returns on new investments that are greater than its cost of capital.

Success invariably attracts competitors whose aggressive practices cut into market share and revenue growth rates, and whose pricing and marketing activities drive down net operating profit margins. A reduction in NOPM drives return on new investment to levels that approach the corporation's WACC. When a company loses its competitive advantage and the return from its new investments just equals its WACC, the corporation is investing in business strategies in which the aggregate net present value is zero.

The length of the Excess Return Period for the corporation will depend on the particular products being produced, the industry in which the company operates, and the barriers for competitors to enter the business. Products that have a very high barrier to entry due to patent protection, strong brand names, or unique marketing channels might have a long Excess Return Period (10 to 15 years or longer). The Excess Return Period for most companies is 5 to 7 years or shorter. All else equal, a shorter Excess Return Period results in a lower stock value.

A company's WACC is very similar to an investment portfolio's weighted average return - it's simply the weighted average expected cost for the company's various types of obligations—debt, preferred stock, and common stock—that are issued by the corporation to finance its operations and investments.

The company's WACC is a very important number, both to the stock market for stock valuation purposes and to the company's management for capital budgeting purposes. In an analysis of a potential investment by the company, investment projects that have an expected return that is greater than the company's WACC will generate additional free cash flow and will create positive net present value for stock owners. These corporate investments should result in an increase in stock prices. These projects are good things! Investments that earn less than the firm's WACC will result in a decrease in stockholder value and should be avoided by the company.

The annual rate of return that an investor expects to earn when investing in shares of a company is known as the cost of common equity. That return is composed of the dividends paid on the shares and any increase (or decrease) in the market value of the shares. For example, if an investor expects a 10% return from McDonald's stock and she buys a share at $67.25, her expectation is to receive $6.72 during the year through a combination of dividends (currently $.34 per share during 1998) and the appreciation of the stock price (presumed to be $6.38 to give her the 10% expected return totaling $6.72) during the year.

Equity Risk Premium = Exp. Return on Market - Risk Free Rate

this method of valuing stocks demands that one pay less than the intrinsic value of the stock. for example, using this method, citi's intrinsic value is about 40 right now.

long c