Discounted Cash Flow (DCF) is a way to figure out how much a company or asset is worth today, based on the money it's expected to make in the future. In simple terms, assets with high and stable cash flows are more valuable than those with low and volatile cash flows.
How DCF Works
The idea behind DCF is that a dollar today is worth more than a dollar tomorrow. Why? Because you can invest today's dollar and it will grow over time.
So, if a company makes $10,000 today, that money is worth more than if it were made a year from now. If you invest today's $10,000 at a 5% interest rate, it would turn into $10,500 in one year.
To find out how much a company is worth, you guess its future earnings and then "discount" them. This means you adjust those future earnings back into today's dollars to see how much they are really worth.
Thus, to calculate the DCF value of a company, we forecast its future cash flows and discount them at a rate that reflects the riskiness of those cash flows.
Calculating DCF Value
To do a DCF calculation, we need two main things: an estimate of how much money the company will make in the future, and a "discount rate" to adjust these future earnings back to today's value.
Free Cash Flow Forecasting
Alpha Spread employs various operating models to calculate a company's free cash flow. The choice of model is algorithmically determined based on the company's characteristics.
Cash flow projections take into account:
- Historical performance, using regression models to estimate future values.
- Industry base rates, factoring in how similar companies have historically behaved.
- Analyst estimates, which include both company-specific and industry-wide projections.
Discount Rate Calculation
Alpha Spread employs either the Weighted Average Cost of Capital (WACC) or the Cost of Equity as the discount rate, depending on the specific model being used. We analyze variables such as risk-free rates, capital ratios, interest coverage ratios, and risk premiums to arrive at the appropriate discount rate.
The Bottom Line
In DCF valuation, an asset's value is the present value of its forecasted future cash flows, discounted at an appropriate rate. Alpha Spread utilizes a proprietary algorithm to estimate future free cash flows and the suitable discount rate.