(DCF valuation) Will the cashflows (per share) of company XYZ, every year in the future (2023...) be added up and go into its shares price every yr

Question

In a DCF valuation, all the cash flows for "x" period of time are added up and discounted back. So let's say this companies share price is $1 and the streets expectations is that the generated cashflow for 2023-2026 will be 0 ( just saying that so we take out the "priced in" aspect)
If in 2023 it makes $0.50 "of free cashflow per share" (revenue) will the price of the stock in 2024 be at least $1.50 (setting aside all extrinsic factors and debt,)? And if from 2024 -2027 it makes $3 FCF will the price of the share in 2027 be at least $4.50 If it won't be 4.50, how can i discount $4.50 back to today (2022) if when i hold on to the share (till 2027) it won't even be worth that much. If it will be 4.50 i thought past cashflows don't affect current price (besides that perhaps it's a good company)

Answer 1

Ah, if only it were that simple...

The stock price reflects what people think the stock is worth now, in terms of what they think it will be worth in the future and the dividends it is expected to pay in the meantime.

Since everyone evaluates this differently, and rationality often has little to do with it, there is no simple mapping between cash flow (or any other metric) and the share price. There are some general influences, but there are too many factors to predict from one in isolation... Or some would say to predict in detail at all, other than on a statistical basis across the entire market

Stealing a line from the sciences: "Under the most rigorously controlled conditions, the organism will do what it damned well wants to do."

Answer 2

That's not quite how DCF models work. DCF does not add cash flows to the share price and then discount the final price back to the present. Instead, each cash flow is discounted back to the present and all of the discounted cash flows are added to find a present value.

The current price of the stock should reflect all of those future cash flows using some discount factor that represents the expected rate of return you want to get for the stock.

That's a pretty simplistic model that involves a lot of assumptions, but that's basically how DCF models work.

Answer 3

The short answer to your question is: Yes, earning more cash than expected in year 1, would, simplistically, increase the value under a DCF valuation method by the amount of that extra cash when calculated next year [if that profit remains as excess liquid cash when you analyze things next year], but you must make sure you consider that value in today's dollars, if you are comparing it against a DCF model already calculated in today's dollars.

There are 2 issues that impact your assumption to be addressed first:

(1) As pointed out, there are many factors in valuing a stock, and different methods used by different people / institutions means that your model's changes don't necessarily impact the share price in an expected way. You semi-acknowledge this by saying "excluding debt and other factors", but you should recognize that those 'other factors' means everything under the sun; they vastly outnumber the impact of this single element of your attempted valuation metric.

(2) A DCF model is always forward looking. Past results only impact the model if it has an actual impact on the current cash you see in the bank, or implied future results. If you own a restaurant, that restaurant is worth 2 things under a DCF model: (a) the liquid value of your net cash [cash in the bank - debt on your balance sheet] + (b) the estimated future cashflows of your restaurant, discounted back using a rate of return that appropriately assigns risk to the likelihood of those estimated cashflows.

In your example, if the company earns more cash than expected, and if the future outlook remains unchanged, and if there are no competing factors, then your own DCF model should indicate a value increase, because the starting liquid net cash position of the company is higher by the amount of cash now in the bank.

Let's look at a simplistic example of using a DCF today and again next year, with the following assumptions for a restaurant business:

Your restaurant has $0k in debt, and $0 in cash today [with 150k of restaurant equipment you already bought yourself*]. You estimate earning $40k free cashflow annually, forever. A fair rate of return given the risk level of the restaurant business is 20%. * Note that the 150k of restaurant equipment is not added to your DCF model, because you can't sell your stove and still make food - the value of your net assets is determined through the creation of free cashflow under this model, only increased by extra non-productive assets that don't impact the cashflow [such as more cash on hand than you need to run the business].

In this example, the value of your restaurant under a DCF method is $40k / 20% [value of a 'perpetuity' earning a flat amount of money at a given discount rate, every year into infinity] = $200k.

Now, over the next 12 months, let's assume that you pull in $0k in net profit, instead of your anticipated $40k. Assume that you still then estimate future free cashflow to be $40k / year, forever, and assume that 20% is still considered a fair discount rate. At that point in time, the value of your restaurant will be $40k / 20% = ... the same $200k in value. Why didn't the value change even though cashflow was less than expected? Because $200k in 2023 dollars is not worth the same as 2022 dollars. At a 20% annual discount rate, having an asset worth $200k in 12 months would be about the same as having an asset worth $166k, today.

Another way to look at this would be to say that today, if you expected to build your restaurant over 12 months, and then expected to earn 40k annually at 20% discount rate, the value today under a DCF model would be (40k/20%)/(1+20%)=166k. and 166k is barely more than the 150k of invested equipment value, so losing that 1st year of income is a massive downside.

Now let's consider what happens in your DCF model if you earn the expected $40k of cash over the next 12 months. If you then go to do a new DCF next year, at that point in time, the value will be 40k / 20% +40k extra cash = 240k net value. An asset worth 240k to you next year, would be worth 200k today using a 20% annual discount rate. So this simply proves the math of how to calculate the value of a perpetuity.

Now, finally let's consider what happens in your DCF model if you earn 50k in the first year, instead of 40k. 40k future revenue for future years / 20% discount rate + 50k cash in the bank = 250k value next year. In today's dollars, that 250k would be worth 250/ 120% = 208k, basically showing that earning an extra 10k in your first year, would be worth 8k to you today, because of the time value of money.

It's hard for me to follow the specific example you pose, because you are jumping between current and future years for purposes of valuation, so those numbers are not directly comparable - they need to be discounted backwards / forwards to match the same year under consideration. Still, the above should provide some guidance on how you can prove this out yourself using your own hypothetical. Again note that this change in value under your calculation may have little bearing on the market price for the shares, as the 'market consensus value' is likely calculated in a multitude of different ways.

Edit to discuss significant complication for share valuation using DCF:

Remember in my example, where I said that the value of the kitchen equipment doesn't get added to a restaurant's DCF, since you couldn't simultaneously sell the stove and still make food? Well for a large enough company, you may need a significant amount of cash floating around to make sure bills get paid on a timely basis. Just like you don't leave your own checking account at $0, a company will leave cash in many nooks and crannies, different countries, etc., for a whole host of reasons.

As a result, while you might theoretically see a scenario where beating this year's estimated FCF allows you to directly add that extra cash to your DCF, in the vast majority of cases, you would never be able to look at the balance sheet of a company and say "of the $150M in cash listed on the FS, $40M is excess cash not needed for operations, and therefore should be added to my DCF model". In most cases, you may need to assume that all cash listed on the FS is required to operate, and therefore cannot be 'added on' to your DCF, without impacting future cashflows.

As a final side note - when earnings beat expectations, you may likely see that the value increases by a large multiple of the direct increase to FCF - because the assumption is often that increased sales today, implies increased sales forever, which will have a much larger multiple effect on a company's future estimated cashflows.