If an investor wants to know the true worth of a company, even before looking at its stock price, what calculation estimates this value by predicting all the money it will make in the future?
The calculation that estimates the true worth of a company by predicting all the money it will make in the future, even before looking at its stock price, is called Discounted Cash Flow (DCF) analysis.
DCF analysis aims to determine a company's intrinsic value. Intrinsic value is the true, inherent worth of a company, independent of current market price fluctuations, derived from its fundamental financial health and future prospects. This method estimates value by projecting a company's future Free Cash Flows (FCF) and then converting these projected future amounts into their equivalent value today.
Free Cash Flow (FCF) represents the cash a company generates after accounting for its operating expenses and capital expenditures needed to maintain or expand its asset base. It is the actual cash flow available to all providers of capital (both debt and equity holders) after the business has covered its needs.
Future cash flows are worth less than immediate cash flows due to the time value of money, which considers factors like inflation, opportunity cost, and investment risk. Therefore, these future Free Cash Flows must be 'discounted' back to their present value. The rate used for this discounting is called the discount rate. This rate reflects the required rate of return for investors, essentially the company's cost of capital, and is commonly represented by the Weighted Average Cost of Capital (WACC).
A typical DCF model involves explicitly forecasting the company's Free Cash Flows for a specific period, often 5 to 10 years. Beyond this explicit forecast period, a Terminal Value is calculated. The Terminal Value represents the present value of all cash flows the company is expected to generate indefinitely into the future, past the explicit forecast horizon. This is often estimated by assuming a stable, perpetual growth rate for the company's Free Cash Flows from that point onward.
The present values of both the explicitly forecasted Free Cash Flows and the Terminal Value are then summed. This total sum provides an estimate of the company's enterprise value. To arrive at the intrinsic value attributable solely to equity investors, net debt and any non-operating assets or liabilities are adjusted from this enterprise value. The resulting figure is considered the estimated true worth of the company's equity based purely on its future cash-generating potential.