Discount Cash Flow Analysis

5 Pages 1374 Words

It is a fact that investors will not invest their money in stocks, which are more risky than U.S. Treasury notes, bills, and bonds, unless they are offered a required rate of return to “commensurate with the risk.” In order to calculate this risk and thus determine whether or not we should invest in a stock, we need to develop tools, which will allow us to calculate the current intrinsic value of a stock. Of course this is assuming that we wish to maximize our possible gains by buying low (undervalued stocks) and selling high (overvalued stocks). The mechanism that we will be using is referred to as the discount cash flow analysis mechanism. This mechanism makes it possible for us to produce a baseline valuation of almost any stock. A baseline value can be defined as an intrinsic value, or value at which the stock should be traded. Discount cash flow analysis is technique developed by Dr. J. Randall Woolridge, professor of finance at Penn State; Dr. Gary Gray, former manager director of a major Wall Street investment bank; and Dr. Patrick J. Cusatis, an associate professor of finance at Penn State and a Vice President of Tucker, Anthony & Co., an investment bank. Discount cash flow techniques are utilized by investment bankers for merger and acquisition analysis, Wall Street traders to value debt obligations, and Wall Street analysts to value stock. Furthermore I will demonstrate how one can take advantage of the fact that market prices don’t always match the intrinsic value of a stock. I will explain exactly what a baseline value is and how we can use it to find a winning stock. Foremost I will outline the four steps used to calculate intrinsic value of a stock. Of course if our estimate indicates that our stock choice is undervalued we will buy it. The first step in this process is to forecast expected cash flow; then we must estimate the discount rate; thirdly we calculate the value of the corporation; and finally w...