Stock Valuation: Why does DCF give us equity value close to the range of the current share price?
Hi,
I am finding it difficult to understand how DCF gives us the equity value in the range of the current share price?
Example: Stock is trading at $110s. How does discounting future earnings, give us a value in the range of say $90-120? I am not able to understand it mathematically why the stock price is PV of future cash flows?
Let's say you start a business with only equity, then balance sheet below:
Assets: 10k
Equity: 10k
If there are 100 shares, then 100 dollars is share price. How does DCF give us value around this range? I am unable to comprehend, please help!
In a very simple way of thinking about it, going off your question. Consider that $10,000 of cash sitting in a briefcase, not earning any interest income or any income for that matter. Since those dollars are not generating cash flow for the business (I.e., they are just sitting there in the briefcase not put to work), the PV of future cash flows is 0. So the enterprise value is 0.
Equity value = enterprise value - debt + cash Equity value = 0 - 0 + $10,000 = $10,000
Of the company has 100 shares, then share price is $100 as you stated. Same conclusion using the DCF. Hope that is helpful to think through.
Hello,
Thank you for replying.
I am finding it hard to understand how present value of future cash flow is equivalent to or in the range of the current share price of a new company.
I am taking my earning ability and forecasting it, then discounting it. How is that giving me a number so close to the share price of say 100 dollars? Why not 1000 or 10 dollars? Because accounting is completely different and that gives me BV of share which is 100, I understand that bit. But how come DCF also lends us a value close to this?
It's magic.
In the above example, I calculated market value of equity, not book value.
Investors price the value of stock based on future cash flows discounted to today’s dollar. Think about it, would you pay $1 for 90 cents? No. You would pay $1 or more. Arbitrage brings that payment to $1. That’s how the market works.
A DCF is full of assumptions of future cash flows. And based on those assumptions you can calculate a stock price. Your DCF can give you a stock price of anything you want by tweaking your assumptions. Obviously you want your assumptions to be as close to reality in terms of probability and risk.
Simply put, your balance sheet equity value is in no way reflective of the market value. Stocks are traded in the open market, and the market values the stock using a DCF. Therefore the market will trade the stock in a range given to you by your DCF.
I think you're thinking about the logic in a backwards sense.
Rather than imagining why the DCF arrives at a similar number to the share price, you should imagine why the share price is similar to the DCF.
Investors want some form of checking how much a company should be worth, and the DCF is one way to do this. Therefore, if the DCF target price is double the company's current value, the investor may decide that the company is undervalued. If enough investors do the same analysis, then the share price will rise due to demand to a figure closer to the DCF target price.
Therefore, it is more apt to imagine the DCF giving influence to the share price, rather than the DCF randomly showing the same number as the share price.
Then with regards to your question about future cash flows, ApplesVSBannans answers this. If I guarantee you $100 next year, then the most you will pay for that investment is the PV of $100. Similar to a company, we imagine that, as an equity investor, we have access to the company's cash flow via our stock holdings and therefore our holdings should be equal to the PV of the cashflows we are holding via the shares.
Perfect, this helped! Yes, I guess during IPOs a company would be valued by methods like DCF so that's the starting point. And again DCF will be used later on so it will give answers in the same range..
This doesn't always mean that DCF's do give accurate estimations of true market value, or even the current market value. At times markets differ greatly from fundamentals, and DCF's are often so arbitrary anyway. Happy to help!
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