When investors estimate Discounted Cash Flow method then will face some various terms like Free Cash Flow, Intrinsic Value, Margin of Safety, Terminal value etc.
Many of people know how to calculate DCF model, but they do not know, what are the meaning of these term. Investors should be know all the terms with actual meaning. So, let's start,
(i) Free Cash Flow:
Free Cash Flow is very crucial metric for value investors, But it doesn't show in cash flow statement. You have to calculate yourself. Free Cash Flow is the cash that a company has left after spending all the money that is required to keep the business running like maintenance cost. Free Cash Flow uses DCF method.
Free Cash Flow = cash from operations - capital expenditures.
If Free Cash Flow increases year on year basis, basically it is good sign for the company.
(a) Cash From Operations:
It shows the cash generated from the main activity which in the company is involved. Like, cash realized from debtors, cash paid as salary etc.
(b) Capital Expenditures:
Capital expenditures also known as CAPEX, refers to the funds that are used by a company to acquire, purchase and upgrade long term assets such as plant, property, building and land etc.
(ii) Intrinsic Value:
The greatest investor Warren Buffett defines Intrinsic Value as follows,
"It is the discounted value of the cash that can be taken out of business during its remaining life".
In simple word, Intrinsic value means the true value of the share price. Basically every shares have real value.
(iii) Margin of Safety:
Margin of Safety is the difference between the share price and Intrinsic value. The value of share so, calculated may vary as the company might not grow same rate. For this reason we advise that to have a considerable Margin of Safety( usually we take between 10% to 20%).
(iv) Terminal Value:
Terminal value is the value of company beyond the explicit forecast period. The rate at which the free cash flow grows beyond 10 years is called the Terminal growth rate.Terminal growth rate is considered to be less than 5%
Terminal value= FCF × (1+ Terminal growth rate )/(Discount rate - Terminal growth rate)
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