Skip to main content
Update
The boards are getting a new home!

We're pleased to announce an update is coming to the community boards.

Saturday, September 24th: We are migrating the boards to a new platform. The site is currently in read-only mode and we will bring it back online as soon as the migration is complete.

Fool.com | The Motley Fool Community
Message Font: Serif | Sans-Serif
 
No. of Recommendations: 0
Brian,

I'm not sure I would say expect, because it is possible that you discount the cash flow estimates at 10% (or another number) and find out the shares are already above that price. Ie. you're looking at a negative potential return. The higher the discount rate the lower your expected value and the more unlikely it is that the stock is undervalued.

If you're curious why this is so.... it is because of how discounting "works." Basically the first year of cash flow is worth (where x = first year cash flows):

Year 1 Value = X / discount rate

The second year is:

Year 2 Value = (X + growth assumption) / (1 + discount rate)^2

The third year is:

Year 3 Value = (2nd year X + growth assumption) / (1 + discount rate)^3

And so on, until you get to the calculation of the terminal year cash flows. You then add up the estimated value for each year and that is the estimated value today.

If you're curious about how it all works there are templates on www.damodaran.com. From there you can input estimates and you'll see that as you raise the discount rate you get a lower estimated value. You'll also see how sensitive the model is to changes in different inputs.

Ultimately these exercises are only as good as the inputs and don't tell you exactly what a company is worth, because its much more likely that the company will ultimately perform a little bit better or worse than estimated, and the natural cycles of fear and greed in the market will push the price higher or lower too. It's still an extremely valuable exercise though, because it helps frame your thinking on growth estimates and risk, and how that ultimately effects value.

Best,

Nathan
Print the post  

Announcements

When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.