In my stock analysis process, among others, one of the methods I use to estimate fair value of a given stock is using 15 year discounted cash flow (DCF). At a fundamental level, what DCF does is, it uses future cash flow estimates and then discounts it to determine the present value. Let us discuss both of these parameters.

Future cash flow estimate: There are myriad of different ways to estimate future cash flow of any corporation. These are based of EPS, free cash flow, operating cash flow, net profit, pre-tax profit, etc. I am not qualified to judge or make any comment on the correctness or appropriateness of using any of above parameters. I believe based on a specific objective any or all could be correct. I look at DCF methodology from my own investing situation and objectives.

I am a long term dividend investor and hence, I use estimates of cash flow from dividends. In addition, I also include an estimation of cash I would receive from selling the stock after 15 years.

Discount Rate: This is the rate at which future cash flow is discounted to determine present value. The general practice is to use cost-of-capital that is available in any given market. I have observed that, typically, discount rate is in the range of 12% to 18% depending upon individual scenarios.

In my calculation, I tend to use 12% in most cases.  Continue reading rest of this article…