Discounted cash-flow

Benjamin Graham long ago argued that a stock’s value is equivalent to the present value of all future dividends (see time value of money). A discounted cash-flow model is a modification of this classic formula for valuing companies based on the net present value of the cash-flow attributable to the stockholder, and uses net earnings or cash-flow instead of dividends. In this respect it is mathematically identical to the dividend discount model.

Discounted cash-flow models can be solved for a chosen unknown variable (e.g., the ‘correct’ stock price, the implied growth rate or the implied discount rate) by using actual or judgemental inputs for the remaining variables (historic earnings, long bond yield, equity risk premium, terminal growth rate).

If the model is solved for the implied growth rate, the method is called a ‘reverse DCF’ model. Some analysts claim this approach to be superior, arguing that it demands no earnings forecast. This is casuistry. Such an approach is only of value if the analyst has some independent means of judging whether the implied growth rate is reasonable or not.

In general, however, earnings ought to be preferred over dividends, since retained profits are still owned by the shareholder. The major criticism over pure discount models is that they are highly sensitive to terminal value assumptions – i.e. the long-term earnings growth and discount rate assumptions made beyond the immediate and supposedly more visible future.