Discounted Cash Flow Model
Previously I have explored Valuation Multiples as a method of valuing a stock. Another method of valuation which I am going to examine today is the Discounted Cash Flow (DCF) analysis.
I will also be sharing the bespoke DCF model that I built as a free download, to all newsletter subscribers so don’t forget to subscribe if you have not already.
The DCF seeks to estimate the value of a stock based on its expected future cash flows. DCF analysis attempts to put a value on the stock today, based on projections of how much money it will generate in the future. The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it can be invested. Consequently, a DCF analysis is appropriate in any situation where someone is paying money in the present with expectations of receiving more money in the future.
DCF analysis derives the present value of expected future cash flows using a discount rate. Investors can use the present value of money to determine whether the future cash flows of a stock are equal to or greater than the value of the initial investment. In theory, if the value calculated through a DCF analysis is higher than the current cost of the investment, the opportunity should be considered.
How the Calculation Works
The core of the DCF calculation consists of projecting free cash flows for the chosen forecast period, estimating the terminal value of the company after the forecast period and calculating their present values. Then, in order to determine the intrinsic value of the company we will need to calculate the sum of the present value of all projected future free cash flows and the present value of the terminal value.
The bespoke DCF model that I developed allows me to quickly perform a DCF analysis with relative ease. The model is automated in Google Sheets meaning that once the key inputs have been updated the model does the rest.
Free Cash Flow (FCF): the cash available for the company to repay creditors or pay dividends and interest to investors.
Where to find it? Simply Google (or whatever search engine you use) “iRobot free cash flow macrotrends”
Growth Rate: the constant rate at which a firm’s expected free cash flows are assumed to grow represented as a percentage.
Where to find it? I like to use the analyst estimates on Yahoo Finance. Simply search for the ticker, navigate to the “Analysis” tab and you will find growth rates near the end. Note that Yahoo finance provides 5 year growth rates whilst my model uses 10 years. For years 6 to 10, I like to use a more conservative estimate based on my own intuition and judgement.
Discount Rate: the rate used to discount future cash flows and represents your opportunity cost as an investor.
Where to find it? I set my discount rate at 10% for all DCF analysis as this is the return that I require on my investments as a retail investor.
Terminal Value: estimated value of a business beyond the explicit forecast period which in this instance is a multiple of the FCF.
Where to find it? The generally accepted range here is between 10 and 15. 15 for really high quality businesses and 10 for a low quality or unproven businesses. Exercise your own judgement.
I developed this particular model in 2020 and so far it has helped to identify stocks including iRobot, Facebook and PayPal which appeared hugely undervalued and have already been sizeable winners for me in a relatively short period of time.
If the intrinsic value that we have calculated is greater than the current market cap of the company then this represents an opportunity to buy the stock at its current market value in expectation of gain.
If the intrinsic value of a stock is less than market cap, the stock is considered overpriced.
The DCF has limitations (like most economic theories) and drawbacks most notably:
Requires a significant number of assumptions
Prone to errors if assumptions are inaccurate
Very sensitive to changes in assumptions
Looks at company valuation in isolation
Ignores relative value of peer companies
I would never solely rely on a DCF analysis when performing due diligence. For high growth stocks that are not FCF positive, the model may spit out some bizarre results given that FCF is a key input.
I personally like to use the DCF as an extra weapon in my armoury when performing due diligence. It can help to give a market sanity check at the very least and provide a ballpark figure. The model that I use is quite simplistic for a reason. I do not place a significant weighting on the DCF analysis as part of my due diligence process therefore I do not want to spend a significant amount of time calculating. There are plenty of far more detailed models available online than the one I use.
If I experience a huge positive variance between the intrinsic value and current market cap it signals to me that I need to look closer. If the the valuation multiples (eg P/E ratio, P/S ratio) are lower relative to competitors and the DCF shows a favourable result this could be pointing towards an undervalued stock.
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Wolf of Harcourt Street
Disclaimer: I am not a financial adviser and I am not here to give specific financial advice. The opinions expressed are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. The information is based on personal opinion and experience, it should not be considered professional financial investment advice. There is no substitute for doing your own due diligence and building your own conviction when it comes to investing.