I was asked by a reader: “If we do 10-year DCF for a stock, does this mean we have to look into 10 year in investing the stock?”
My response: NOT REALLY.
- By trying to help the reader to look from different perspective, I extended his question:”To get the total value of a company by using DCF, besides the 10-year projection, we also have to calculate Terminal Value. Terminal Value is necessary because we believe the company will continue generating profits for a very long time (infinity). Does this mean we have to invest in that company forever?”
Remember: We have to discount the projected cash flow (near future value) and terminal value (far future value) to present value, at our discount rate. In this context, the present value means the company value as of the date we do the analysis. In other way, we can say the present value is our intrinsic value.
DCF doesn’t tell you the timeframe of your investment, or how long you should invest.
Thus, in theory, back to basics,
- Asking price > Intrinsic Value – Don’t invest or sell
- Asking price < Intrinsic Value – Invest!
- Intrinsic value derived from DCF is usually less conservative if compare to Dividend Discounted Model and P/E. Sometimes, a stock may need longer timeframe to approach the intrinsic value. This is probably the reason you have to invest (and wait) for longer term.
- “How long you should invest in a stock” – This depends on your investment plan. DCF is just a small part of your investment plan. Well, investment plan is another huge topic.
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