Using Discounted Cash Flows

One of Benjamin Graham’s greatest teachings is that when looking at the stock of a company and trying to value it, we should use the same approach as we would if we were to purchase a small business from a neighbor.  The only difference between the companies is size, so why should we as investors continually place more emphasis on the market’s speculation of stock price than the actual value?  Well, we shouldn’t.  We should only care about the intrinsic value of the company, and only purchase securities that are trading below that value.  Sounds pretty simple, doesn’t it? 

The complication comes in when we try to figure out the value of the company.  How does one go about doing that with accuracy?  Well, there are many approaches – one of which is the Discounted Cash Flow Analysis.  The idea is simple:  predict the future cash flows of the company and discount them to the present using the time value of money.  But Benjamin Graham taught us never to base our investments on predictions of the future, which are habitually wrong.

I believe that the intelligent investor can get around this prediction issue by believing another of Graham’s philosophies – the margin of error.  If you put a significant margin of error into your prediction, it becomes more reliable.  If I value a company at $35/share, but refuse to buy it unless it is trading below $26.25, I have a margin of error of 25%.  At that level I can feel more certain that I am not wrong.  

David Meier from The Motley Fool has written a nice article about using DCF, and the pitfalls against it.  The article can be found here:  http://www.fool.com/news/commentary/2005/commentary05032803.htm

Quicken.com has a very helpful tool for estimating the value of a company based on DCF.  To use it, go to http://www.quicken.com/investments/seceval/ and enter a ticker symbol.  After the evaluator comes up for the stock you enter, click on 5. Intrinsic Value.  There you can select different growth and discount rates to see how they affect the value.

~Ben

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