It is important to know what a company is actually worth when you want to invest in the company. Over the years, many methods are developed to calculate the actual value of a company. These methods differ from the calculation of the value on the short or long term, based on the value of the assets of a company or the future earnings of a company. The discount model is based on future earnings of a company. This method was developed by John Burr Williams and is used by successful investors such as Warren Buffett to determine the value of a company.
Warren Buffett and all other investors who are using this method, assume that the value of a company can be determined by summing up all future cash flows and discount this total. Because nobody can see into the future, the discount model uses cash flows from the past and extrapolate these into the future. The growth rate is calculated, and this growth rate is used to calculate the revenues for a certain number of years. This way, the discount model can be used to predict the future.
Because a company will not grow always as fast as it does now, the growth of future cash flows for a predefined number of years is calculated. After a certain number of years the growth of the cash flows will slow down. The discount model also takes into account the cash flows after the predefined number of years of fast growth. After these years, a standard growth factor is used to calculate the cash flows further into the future. These cash flows can also be discounted with this discount model of John Burr Williams.
If the value of a company is calculated using the discount model, it is easy to determine the value of a share. And that is what you as an investor want to know: "What is the fair value of a share and which company I can best invest in?".
Because every investor has his own preference with which cash flow the calculation works best, there are various methods of calculation possible. John Burr Williams calculated with dividends, while Warren Buffett uses cash flows as a input parameter in the discount model.
The discount model can calculate with the following input parameters:
- Net profit - the profit a company makes is one of the most important factors for determining the value of a company. The growth of these profits is therefore a major factor to value the shares of a company.
- Cash flow: Net income and depreciation - in lots of literature, cash flow is calculated as the net income and depreciation. This method can be used to calculate the growth rate with the net profit and depreciation.
- Cash flow: Net cash change - the net cash flow is the difference between the total cash which goes into a company less the total of cash that leaves a company. This method can also be used with the discount model.
- Dividends - for many investors dividends are an important factor to invest in a company. The expected growth in dividends can be calculated and all future dividends can be discounted with this model.