How to value a stock using DCF

How to value a stock using a DCF

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Determining the stock value is most accurate when using a DCF analysis. The method is rather simple, but the reasoning behind the assumptions is crucial to avoid investing mistakes. In this article we look at how to perform a DCF analysis and what factors to think about when valuing a stock.

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Warren Buffett on stock value

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

Warren Buffett, owner’s manual 2002

The value of the DCF analysis is called the present value or intrinsic value. This means the value today of the future cash flows that the investor will receive. The value from the DCF is the present value of a stock that you need to buy it at to get at least your required rate of return.

What is a DCF analysis?

DCF means discounted cash flow analysis. Essentially, this means figuring out the cash flows that an asset will produce in e.g. the next 10 years and then discounting it back to determine the value of these cash flows today. Discounting is nothing more than dividing the cash flows by a certain percentage. We do this because we expect a certain return on our money.

The value of the DCF is the price that you need to pay for the stock to achieve your required rate of return. Obviously, this assumes that the assumptions of your DCF hold over time. A stable business will increase these chances. The task of the investor is to figure out the cash flows of the stock and the certainty of these cash flows.

Valuing a stock if mostly done via DCF or multiples. You could also simply look at the book value, but the value of a stock is determined by what the assets will earn over time, not by the book value.

DCF is used to determine how much the cash that a business will produce in the future is worth today. The input (assumptions) for a DCF are:

  1. The current free cash flow
  2. The growth rate
  3. The discount rate
  4. A multiple to determine the terminal value (i.e. the stock price in e.g. 10 years)

DCF a stock value example

The figure below shows the discounted cash flow formula. You simply divide the cash flows over the discount factor (the 1/(1+r)^n) and then add all these numbers up. The blue part shows that the value of the cash flow is lower in the future, this is due to the discounting. I.e. 100 million today is worth more than getting 100 million in 4 year (see time value of money below).

The terminal value is the expected value of the company in the future. This is often determined by multiplying the cash flow by a multiple (e.g. the P/E or P/Cash Flow multiple). The example shows a static cash flow, so no growth is assumed over the years here. Note that $100 is the cash flow, r is the percentage at which you discount and n is the number of years.

How to value a stock with DCF
An example of the DCF analysis (source: Corporate Finance Institute)

1. Starting Cash Flow

The starting cash flow is basically the free cash flow that you can find on the statement of cash flows. You can use the free cash flow of the company or the free cash flow per share. This will be earnings of the business that we will let grow and then discount to determine what the business is worth today.

The following article shows how to determine the free cash flow by looking at Apple. The importance of cash flow can be found here.

2. Growth rate

After establishing the cash flow, you need to think about the growth of this cash flow. The higher the growth, the higher the future cash flows. It is essential that you’re conservative here and look at the last 10 years and 5 years to determine the growth rate and if it is slowing down or increasing. Also, it could help to look at what analysts think about the future growth. Ideally, you’re specific knowledge will determine how fast the business will grow.

The moat (competitive advantage) will determine the certainty that we can have in the future growth of a business. It can help to make a scenario of neutral, positive and low growth based upon your estimations. Changing the growth rate and terminal value P/E multiple is also called sensitivity testing. So, you basically see how different scenarios will influence the future cash flows.

Growth is also related to the incremental returns on capital that a business can achieve. This deserves more attention, but in short the best business is one that can deploy its incremental capital consistently at high rates of return as long as possible.

If a business becomes more mature (e.g. McDonalds) than the company will return capital to shareholders in the form of dividends and/or share buy-backs. This is much appreciated by most investors, but it would be preferable if the all the capital (incremental or additional) is reinvested against high returns. So, ideally you want McDonalds to invest its capital in order to operate more restaurants that earn e.g. 20-30% returns on capital instead of paying out capital in the form of a dividend that is taxed.

3. Discounting and the time value of money

Cash that you will receive in the future is worth more today than in a year. This is due to the opportunity that you have to invest the money. You can always put your money into a bank account or government bond to get a safe return. Treasury bonds and your saving account will provide you with an almost guaranteed interest percentage. Investing in stocks or other assets will mean that you give up this ‘guaranteed’ return for a more uncertain return.

Low bond yields today offer an investor less opportunity for a safe return. So, the investor is more inclined towards investing and putting his money into stocks or other assets. If bonds would offer a 10 percent yield, then many more investors would prefer this safe option. This is an important reason why stock prices are so high today (because bond yields are very low).

Why we need discounting

Discounting is used to determine the value today of a future cash flow. In Finance you learn that the appropriate discount rate is the WACC (weighted average cost of capital). The WACC basically tells you the costs that a company pays on its debt (interest) and equity (required return for shareholders). You discount with the WACC to make sure that the return of the cash flow is higher than the costs of debt and equity.

The WACC uses the beta for risk (which measures volatility of the stock compared to the market). Warren Buffett does not believe in this method. High returns on capital and the one dollar rule ensure that the business is earning more than the costs of the debt and equity.

Warren Buffett and his discounting rate

Warren Buffett uses the treasury long term bond rate. He discounts with the bond rate to compare the cash flow of a stock to the treasury yield. Another way to think of it is in the way of required rate of return. The more return you want, the higher the discount rate. This means that the net present value will be lower because the denominator is higher with a high discount rate. You basically say that you value money today a lot, and want a high return for investing your money.

Of course, discounting with high discount rates can turn out to be too conservative. In sum, discounting is dividing the cash flow over the discount factor (e.g. 10% like the figure above). Discounting hence reduces the future value of the cash flow to take into account that a dollar today is worth more than a dollar into the future. Current bond yields and the investors own preferences will mostly determine how much future cash flows are worth.

Selecting an appropriate discount rate

The discount rate determines your desired return. It is the return that would make the investor indifferent between the present and future value. So, the discount factor corrects the future cash that the business will earn for the other investment opportunities (Treasury Bond). Often an additional addition to the Treasury return (yield) is added to increase the margin of safety. As you don’t want to discount the future cash flow at a rate that is too low. This will lead to overvaluation.

A useful rule of thumb: the more uncertainty about the future cash flows, the higher the discount rate should be. In times of low interest rate (like is the case in 2020) it is safer to prepare for higher interest rates in the future by applying a higher discount rate. Especially now that many companies trade at high multiples to earnings.

In general, excellent companies like Coca Cola and Johnson & Johnson could be discounted at a lower rate than an uncertain business. This is because the future cash flows are more predictable. The DCF will be most accurate in this case. A restructuring case requires another analysis for example because it is more important to figure out if the company will return to a positive cash flow first. These companies lack consistency of the cash flow which makes them less suitable for a DCF.

4. Determining the terminal value

The terminal value is the cash flow that we determined by letting the current cash flow growth with a certain growth rate for e.g. 10 years multiplied by a reasonable multiple. So we say that the cash flow is $20 in 10 years and that the average multiple was 10 the last 5 years. If we multiple $20 with 10 then we get $200 of cash flow in 10 years. We do need to discount this number as well of course by our discount rate to the power of 10 (as it’s 10 years in the future).

Alternatively, the Gordon growth model can be used instead of a multiple. The Gordon growth model divides the cash flow in the terminal year by the difference between the discount rate and the long term growth rate. The higher the expected growth rate in the future, the lower the denominator (e.g. discount factor – growth rate). This will lead to a higher terminal value. Logically, the higher the future growth the more the stock will be worth. Here we focus just on the multiple.

Buffett will likely pay not much attention to a terminal value. He will just look at which rate the earnings will growth over the years (incremental return on invested capital). And keep the business as long as the intrinsic value can increase.

We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate.

Warren Buffett, 1987

Stock value is a range and no exact number

There is no exact science to determine the stock value. Many investors are talking about the art of investing as investing is an art combined with science.

You should use the DCF to determine a reasonable range for buying a stock. The DCF can help to determine what price to pay to achieve a certain required return. In this market, you will probably find that most known stocks will not offer 12-15% returns due to the high price. That means that we need to be patience and wait until prices drop before buying the stock.

Making a watch list of companies that you understand and writing down the DCF price will help to buy the stocks at a reasonable price. Remember, the price will determine the return that will get (lower price higher return over time). No business, no matter how good, is worth an infinite price. If you pay too much (e.g. for Microsoft) then it can take 10 years or more before you get back your purchasing price after a crash.

Microsoft stock 1990-2020
Microsoft stock 1990-2020 shows value of 1999 and the time the investor had to wait for a price recovery (source: marcrotrends)

DCF should be used conservatively

DCF is likely the best tool for determining the intrinsic value of a stable company. However, the assumptions of e.g. growth can greatly influence the net present value. The calculation is rather easy, but using reasonable estimates requires some business knowledge and understanding of the stock market and principles.

It is smart to not value a stock if the business is unstable, or you’re not sure about the future cash flows. It’s far better to buy a couple of businesses of which you’re very certain about for a good price. Hence, the need to operate in your circle of competence.

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