Discount model part 2: Cash flow

In part one of the discount model series, the different discount model types and the calculation of the discount model are discussed. Part two of the discount model article series is aimed at the cash flow discount model (or discounted cash flow model). In this article the reason why the cash flow is used in the discount model, what the different types of cash flows are and the shortcomings of the discounted cash flow models.

Successful investors, like Warren Buffett and John Burr Williams have used different discounted cash flow models to value the companies in which they invest. This is a good reason to at least read into the discounted cash flow and how it is used.

Cash flow as valuation indicator

Successful investors use the cash flow for determining the value of the company. These investors believe the cash flow is the only real representation of the earnings of a company. At least the cash flow is an important indicator of the healthiness of a company. A positive and growing cash flow gives a company an edge over a company with a negative or decreasing cash flow.

The discounted cash flow model is used to calculate the net present value of all future cash flows. As mentioned in the previous article about discount models, these discount calculations are used to calculate the net present value of a share or company. So, the current cash flow and a estimation of the future cash flows, you can determine whether the company is overvalued or undervalued.

Pros of discounted cash flow models

A number of different positive points can be named for using the cash flow when calculate the future earnings for companies. First of all the cash flow represent the net income of a company. Cash flows do not only take the profit into account, but also the depreciation and amortization.

Successful investors have used the discounted cash flow model. I must admit that this is not the best reason. But because successful investors have used the cash flow, the calculating the company value using the cash flow did at least not made them unsuccessful.

Cash is important for investors. Without cash, a company can not pay dividends or buy anything else. So a positive cash flow should make investors happy, even more when the cash flow is increasing year on year.

Cons of discounted cash flow models

Besides the advantages of using the cash flow for the calculation of future earnings, some disadvantages exist. The cash flow can be misinterpreted when the company has lots of benefits or costs that increase or decrease the cash flow. When this happens, the cash flow does not represent the earnings of the normal company operations. The cash flows can not be compared over the different years, and using the cash flow for calculate the net present values of the earnings is useless.

Another disadvantage is the determination of the cash flow. Different investors use different cash flows. Some use the complicated net cash flow, which is calculated using the profit, increase or decrease of the account payables and receivables, increase of provisions etcetera. Others calculate the cash flow by adding the depreciation and amortization to the net profit. And another group of investors only calculate the cash flow by calculating the increase or decrease in cash and cash equivalents.

And of course: cash flows and growth of the cash flow in the past do not guarantee anything. But this is no different than the other discount calculations.

Discount model: what else

Part 1 of the discount model series.

Calculate the discounted cash flow using this calculation tool.