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The intrinsic value of a company is the Net Present Value (NPV) of all future cash flows the company will generate.

An investor is interested in the intrinsic value in order to identify undervalued or overvalued companies.

When the intrinsic value of a company is higher than its market value, the stock is undervalued.

When the intrinsic value of a company is lower than its market value, the stock is overvalued.

**Discounted Cash Flow is the model usually employed to calculate the Net Present Value.**

**VALUE INVESTING**

The main goal of a value investing activity is to identify undervalued companies; a value investor buy stocks when the market value of a company is below its intrinsic value, and sell when the market will recognize the intrinsic value and the price will increase.

Benjamin Graham and Warrant Buffett are widely considered the fathers of value investing activity.

Value investing is not a perfect science; intrinsic value calculation is complex and based on subject assumptions. Two or more investors can have a different opinion about the intrinsic value of a company and the idea to buy at a discount and sell when the market will recognize the intrinsic value does not always happen in the real world!

## Discounted Cash Flow Formula

**Discounted Cash Flow = FCF1/(1+r)1 + FCF2/(1+r)2 +….. FCFn/(1+r)n**

FCF= Free Cash Flow

r = the discount rate = WACC

### Free cash flow

Free Cash Flow is the difference between cash generates from operating activities and investments in long term assets (CAPEX).

Free Cash Flow represents the funds generates by the company and available to creditors and shareholders.

Free Cash Flow is a key indicator of company health, and an entire section of this web site is dedicated to this important result (visit the section).

**Free Cash Flow (FCF) = Cash Flow from Operating Activities – CAPEX**

In order to calculate the intrinsic value of a company, an investor has to identify the future Free Cash Flows of the entity. The calculation is not an easy task because different key factors should be taken into consideration. Some of them are listed below:

**1. Mature vs growing companies**

A mature company with a long consolidated presence in the market is usually able to guarantee a stable trend of Free Cash Flows; FCF of the last 5-10 years is generally a reasonable estimate of the FCF the company will generate in the next 5-10 years.

A growing company rarely shows this stable trend.

A growing company is usually a young firm that operates in a new market. At the beginning of its activity, this entity is not normally able to generate enough cash flow from its core business to support all the investments and its Free Cash Flow can be negative. When the company increases its presence in the market, and sales start to grow, its free cash flow turns into positive and increase as well.

It is normal practice to calculate the Free Cash Flow of growing companies by considering different steps as follows:

- Future FCF is calculated for the first 2-3 years
- Two or three different steps are introduced after with different growth rates that should reflect the future development of the company’s activity.

**2. General economic and sector trends**

Company results depend on the future trend of the general economy and the sector where the entity operates.

Macroeconomic analysis is important to estimate the future FCF of a firm correctly; the study should also consider the β of the company in order to understand how the entity reacts to the movement of the market.

(β is explained in the CAPM section).

**3. Company strategy**

Future FCF also depends on future company’s strategy.

EXAMPLE

If company A plans to renew its old equipment in the next 3-5 years, the calculation of future FCF should consider that CAPEX amounts will increase with the consequence that FCF will be reduced.

These examples show that future Free Cash Flows rely on a variety of factors difficult to estimate, in particular in the long period. For this reason, an explicit forecast is not calculated for more than 3-5 years; a Terminal Value is calculated after.

Terminal value is the estimated cash flow values beyond the explicit forecast period. It is a critical part of the model because it usually represents a large percentage of the total amount that is discounted.

DCF model is very sensitive to the assumption made to the Terminal Value; this is the reason why a sensitivity analysis is usually applied along with the perpetual growth rate method.

When the Terminal Value is calculated using the perpetual growth rate method, the assumption is that the company will generate an amount of Free Cash Flow that will increase by a fix growth rate forever.

**Terminal Value = FCFn * (1+g) / WACC – g**

FCF = Free Cash Flow at year n

g = perpetual growth rate of FCF

WACC = weighted average cost of capital

** The calculation of future FCF is not an easy task!**

**The risk is to underestimate or overestimate the Net Present Value:**

Estimating future Free Cash Flows too high could result in choosing investments that might not pay off in the future

Estimating future Free Cash Flows too low could result in missed opportunities.

### Discount rate

When the Discounted Cash Flow model is used to calculate the intrinsic value of a company, WACC is the discounted rate normally applied.

WACC takes into consideration the costs of all funds the company has received by the creditors and the shareholders to develop the activity.

WACC is a critical component of the DCF formula, and an entire section of this web site is dedicated to this important rate.

WACC section deeply analyzes all parts of the equation, also showing the difficulties in the calculation.