Upbeat music plays throughout.
On screen text: Cameron May, Education Coach.
Narrator: Using a discounted cash flow, or DCF, model to calculate the intrinsic value of a stock is a mix of science and art. The math part is pure science. Choosing what numbers go into the math is more art. First, let's tackle the science behind the math.
Begin by using a measure of current cash flow to represent the current value of a company.
Animation: Cash flow growth rate chart from zero to 11 years. Green bars increase in height from zero to 11.
Narrator: Then, apply a growth rate to calculate how much that value might increase over time as the company grows.
Finally, apply a discount rate to account for risk. This can indicate how much the company's future growth is worth now.
Animation: Each bar on the cash flow growth rate chart from zero to 11 years decreases as the discount rate is applied.
Narrator: And that's how you estimate the intrinsic value of the stock.
And yet, stock prices are constantly moving as people buy and sell shares at different prices.
Clearly, every market participant has a different expectation of a given stock's future performance and risk, even with mathematical valuation models like the DCF model. This is where the art side of the equation comes in. Different expectations lead to different stock valuations.
To illustrate this point, here's a hypothetical stock with annual earnings of $1 per share.
Let's suppose one investor expects earnings to grow at a conservative 5% per year. In 10 years, the expected earnings for the company would be $1.63 per share.
But suppose another investor expects earnings for the same stock to grow at a more accelerated 10% per year, because he thinks a new product might sell better than expected. Well, in 10 years, the expected earnings would be $2.59 per share.
The discrepancy between $1.63 and $2.59 might not seem like much, but it's nearly a 60% difference. The investors are likely to end up with very different views of how much that stock is worth.
As you can see, a small change in just one variable, like the growth rate over time, can make a huge difference.
The same is true with other variables like the discount rate.
But just because valuation analysis is a mix of art and science doesn't mean you can't make educated decisions. With experience and support, you can learn to make reasonable assumptions. Even if your estimate of a stock's intrinsic value is just that–an estimate—conducting thorough analysis can help give you confidence that your estimate is built on a solid foundation.
Onscreen text: [Schwab logo] Own your tomorrow®
