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By Ben McClure Contact Ben It can be hard to understand how stock analysts come up with "fair value" for companies, or why their target price estimates vary so wildly. The answer often lies in how they use the valuation method known as discounted cash flow (DCF). However, you don't have to rely on the word of analysts. With some preparation and the right tools, you can value a company's stock yourself using this method. This tutorial will show you how, taking you step-by-step through a discounted cash flow analysis of a fictional company. In simple terms, discounted cash flow tries to work out the value of a company today, based on projections of how much money it's going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as"discounted" cash flow because cash in the future is worth less than cash today. (To learn more, see The Essentials Of Cash Flow and Taking Stock Of Discounted Cash Flow.) For example, let's say someone asked you to choose between receiving $100 today and receiving $100 in a year. Chances are you would take the money today, knowing that you could invest that $100 now and have more than $100 in a year's time. If you turn that thinking on its head, you are saying that the amount that you'd have in one year is worth $100 dollars today - or the discounted value is $100. Make the same calculation for all the cash you expect a company to produce in the future and you have a good measure of the company's value. There are several tried and true approaches to discounted cash flow analysis, including the dividend discount model (DDM) approach and the cash flow to firm approach. In this tutorial, we will use thefree cash flow to equity approach commonly used by Wall Street

analysts to determine the "fair value" of companies. As an investor, you have a lot to gain from mastering DCF analysis. For starters, it can serve as a reality check to the fair value prices found in brokers' reports. DCF analysis requires you to think through the factors that affect a company, such as future sales growth and profit margins. It also makes you consider the discount rate, which depends on a riskfree interest rate, the company's costs of capital and the risk its stock faces. All of this will give you an appreciation for what drives share value, and that means you can put a more realistic price tag on the company's stock. To demonstrate how this valuation method works, this tutorial will take you step-by-step through a DCF analysis of a fictional company called The Widget Company. Let's begin by looking at how to determine the forecast period for your analysis and how to forecast revenue growth. Next: DCF Analysis: The Forecast Period & Forecasting Revenue Growth Table of Contents 1. 2. 3. 4. 5. 6. 7. DCF Analysis: Introduction DCF Analysis: The Forecast Period & Forecasting Revenue Growth DCF Analysis: Forecasting Free Cash Flows DCF Analysis: Calculating The Discount Rate DCF Analysis: Coming Up With A Fair Value DCF Analysis: Pros & Cons Of DCF DCF Analysis: Conclusion

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The Forecast Period The first order of business when doing discounted cash flow (DCF) analysis is to determine how far out into the future we should project cash flows. For the purposes of our example, we'll assume that The Widget Company is growing faster than thegross domestic product (GDP) expansion of the economy. During this "excessive return" period, The Widget Company will be able to earn returns on new investments that are greater than its cost of capital. So, our discounted cash flow needs to forecast the amount of free cash flow that the company will produce for this period. The excess return period tells us how far into the future we should forecast the company's cash flows. Alas, it's impossible to say exactly how long this period of excess returns will last. The best we can do is make an educated guess based on the company's competitive and market position. Sooner or later, all companies settle into maturity and slower growth. (The common practice with DCF analysis is to make the excess return period the forecast period. But it is important to note that this valuation method does not restrict your analysis to only excess return periods - you could estimate the value of a company growing slower than the economy using DCF analysis too.) The table below shows good guidelines to use when determining a company's excess return period/forecast period:

Company Competitive Position Slow-growing company; operates in highly competitive, low margin industry Solid company; operates with advantage such as strong marketing channels, recognizable brand name, or regulatory advantage Outstanding growth company; operates with very high barriers to entry, dominant market position or prospects

5 years

10 years

Figure 1

How far in the future should we forecast The Widget Company's cash flows? Let's assume that the company is keeping itself busy meeting the demand for its widgets. Thanks to strong marketing channels and upgraded, efficient factories, the company has a reasonable competitive position. There is enough demand for widgets to maintain five years of strong growth, but after that the market will be saturated as new competitors enter the market. So, we will project cash flows for the next five years of business. Revenue Growth Rate We have decided that we want to estimate the free cash flow that The Widget Company will produce over the next five years. To arrive at this figure, the standard procedure is to forecast revenuegrowth over that time period. Then (as we will see in later chapters), by breaking down after-tax operating profits, estimated capital expenditure and working capital needs, we can estimate the cash flow the company will produce. Let's start with top line growth. Forecasting a company's revenues is arguably the most important assumption one can make about its future cash flows. It can also be the most difficult assumption to make. (For more on forecasting sales, see Great Expectations: Forecasting Sales Growth.) We need to think carefully about what the industry and the company could look like as they evolve in the future. When forecasting revenue growth, we need to consider a wide variety of factors. These include whether the company's market is expanding or contracting, and how its market share is performing. We also need to consider whether there are any new products driving sales or whether pricing changes are imminent. But because that future can never be certain, it is valuable to consider more than one possible outcome for the company. First, the upbeat revenue growth scenario: The Widget Company has grown revenues at 20% for the past two years, and your careful market research suggests that demand for widgets will not let up any time soon. Management - always optimistic - argues that the company will keep growing at 20%.

That being said, there may be reasons to downplay revenue growth expectations. While the company's revenue growth will stay strong in the first few years, it could slow to a lower rate by Year 5 as a result of increasing international competition and industry commoditization. We should err on the side of caution and conservatism and assume that The Widget Company's top line growth rate profile will commence at 20% for the first two years, then drop to 15% for the next two years and finally drop to 10% in Year 5. Posting $100 million of revenue in its latest annual report, the company is projected to grow its revenues to $209.5 million at the end of five years (based on realistic, rather than optimistic, growth expectations).

Forecast Revenue Growth Profiles Current Year Year 1 Year 2 Year 3 Year 4 Year 5 Optimistic: Growth Rate 20% 20% 20% 20% 20% Revenue $100 M $120 M $144 M $172.8 M $207.4 M $248.9 M Realistic: Growth Rate 20% 20% 15% 15% 10% Revenue $100 M $120 M $144 M $165.6 M $190.4 M $209.5 M Figure 2

Now that we've determined our forecast period and our revenue growth for that period, we can move on to the next step in our analysis, where we will estimate the free cash flow produced over the forecast period.

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By Ben McClure Contact Ben Now that we have determined revenue growth for our forecast period of five years, we want to estimate the free cash flow produced over the forecast period.

Free cash flow is the cash that flows through a company in the course of a quarter or a year once all cash expenses have been taken out. Free cash flow represents the actual amount of cash that a company has left from its operations that could be used to pursue opportunities that enhance shareholder value - for example, developing new products, paying dividends to investors or doing share buybacks. (To learn more, see Free Cash Flow: Free, But Not Always Easy.) Calculating Free Cash Flow We work out free cash flow by looking at what's left over from revenues after deducting operating costs, taxes, net investment and the working capital requirements (see Figure 1). Depreciation andamortization are not included since they are non-cash charges. (For more information, seeUnderstanding The Income Statement.)

In the previous chapter, we forecasted The Widget Company's revenues over the next five years. Here we show you how to project the other items in our calculation over that period. Future Operating Costs When doing business, a company incurs expenses - such as salaries, cost of goods sold (CoGS),selling and general administrative expenses (SGA), and research and development (R&D). These are the company's operating costs. If current operating costs are not explicitly stated on a company's income statement, you can calculate them by subtracting net operating profits - or earnings before interest and taxation (EBIT) - from total revenues. A good place to start when forecasting operating costs is to look at the company's historic operating cost margins. The operating margin is operating costs expressed as a proportion of revenues.

For three years running, The Widget Company has generated an average operating cost margin of 70%. In other words, for every $1 of revenue, the company incurs $0.70 in operating costs. Management says that its cost cutting program will push those margins down to 60% of revenues over the next five years. However, as analysts and investors, we should be concerned that competing widget factories might be built, thus squeezing The Widget Company's profitability. Therefore, as we did when forecasting revenues, we will err on the side of conservatism and assume that operating costs will show anincrease as a percentage of revenues as the company is forced to lower its prices to stay competitive over time. Let's say operating costs will hold at 65% of revenues over the first three projected years, but will increase to 70% in Year 4 and Year 5 (see Figure 2). Taxation Many companies do not actually pay the official corporate tax rate on their operating profits. For instance, companies with high capital expenditures receive tax breaks. So, it makes sense to calculate the tax rate by taking the average annual income tax paid over the past few years divided by profits before income tax. This information is available on the company's historic income statements. Let's assume that for each of the past three years, The Widget Company paid 30% income tax. We will project that the company will continue to pay that 30% tax rate over the next five years (see Figure 2). Net Investment To underpin growth, companies need to keep investing in capital items such as property, plants and equipment. You can calculate net investment by taking capital expenditure, disclosed in a company's statement of cash flows, and subtracting non-cash depreciation charges, found on the income statement. Let's say The Widget Company spent $10 million last year on capital expenditures, with depreciation of $3 million, giving net investment of $7 million, or 7% of total revenues (see Figure 2). But in the two prior years, the company's net investment was much higher: 10% of revenues.

If competition does intensify in the widget industry, The Widget Company will almost certainly have to boost capital investment to stay ahead. So, we will assume that net investment will steadily return to its normal level of 10% of sales over the next five years, as seen in Figure 2: 7.6% of sales in Year 1, 8.2% in Year 2, 8.8% in Year 3, 9.4% in Year 4 and 10% in Year 5.

Figure 2 - Forecasting The Widget Company\'s operating costs, taxes, net investment and change in working capital over the five-year forecast period

Change in Working Capital Working capital refers to the cash a business requires for day-to-day operations, or, more specifically, short-term financing to maintain current assets such as inventory. The faster a business expands, the more cash it will need for working capital and investment. Working capital is calculated as current assets minus current liabilities. These items are found on the company's balance sheet, published in its quarterly and annual financial statements. At year end, The Widget Company's balance sheet showed current assets of $25 million and current liabilities of $16 million, giving net working capital of $9 million.

Net change in working capital is the difference in working capital levels from one year to the next. When more cash is tied up in working capital than the previous year, the increase in working capital is treated as a cost against free cash flow. Working capital typically increases as sales revenues grow, so a bigger investment of inventory andreceivables will be needed to match The Widget Company's revenue growth. In our forecast, we will assume that changes in working capital are proportional to revenue growth. In other words, if revenues grow by 20% in the first year, working capital requirements will grow by 20% in the first year, from $9 million to $10.8 million (see Figure 2). Meanwhile, we will keep a close watch for any signs of a changing trend.

Figure 3 - Free cash flow forecast calculation for The Widget Company

As you can see in Figure 3, we've determined our estimated free cash flow for our forecast period. Now we are one step closer to finding a value for the company. In the next section of the tutorial, we will estimate the value at which we will discount the free cash flows. Next: DCF Analysis: Calculating The Discount Rate

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By Ben McClure Contact Ben Having projected the company's free cash flow for the next five years, we want to figure out

what these cash flows are worth today. That means coming up with an appropriate discount rate which we can use to calculate the net present value (NPV) of the cash flows. So, how do we figure out the company's discount rate? That's a crucial question, because a difference of just one or two percentage points in the cost of capital can make a big difference in a company's fair value. A wide variety of methods can be used to determine discount rates, but in most cases, these calculations resemble art more than science. Still, it is better to be generally correct than precisely incorrect, so it is worth your while to use a rigorous method to estimate the discount rate. A good strategy is to apply the concepts of the weighted average cost of capital (WACC). The WACC is essentially a blend of the cost of equity and the after-tax cost of debt. (For more information, seeInvestors Need A Good WACC.) Therefore, we need to look at how cost of equity and cost of debt are calculated. Cost of Equity Unlike debt, which the company must pay at a set rate of interest, equity does not have a concrete price that the company must pay. But that doesn't mean that there is no cost of equity. Equity shareholders expect to obtain a certain return on their equity investment in a company. From the company's perspective, the equity holders' required rate of return is a cost, because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. Therefore, the cost of equity is basically what it costs the company to maintain a share price that is satisfactory (at least in theory) to investors. The most commonly accepted method for calculating cost of equity comes from the Nobel Memorial Prize-winning capital asset pricing model (CAPM), where: Cost of Equity (Re) = Rf + Beta (Rm-Rf). Let's explain what the elements of this formula are: Rf - Risk-Free Rate - This is the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries. The interest rate of U.S. Treasury bills or the long-term bond rate is frequently used as a proxy for the riskfree rate.

- Beta - This measures how much a company's share price moves against the market as a whole. Abeta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market's movements; less than one means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold mining company), which means the share price moves in the opposite direction to the broader market. (To learn more, seeBeta: Know The Risk.) (Rm Rf) = Equity Market Risk Premium - The equity market risk premium (EMRP) represents the returns investors expect, over and above the risk-free rate, to compensate them for taking extra risk by investing in the stock market. In other words, it is the difference between the risk-free rate and the market rate. It is a highly contentious figure. Many commentators argue that it has gone up due to the notion that holding shares has become riskier. Barra and Ibbotson are valuable subscription services that offer up-to-date equity market risk premium rates and betas for public companies. Once the cost of equity is calculated, adjustments can be made to take account of risk factors specific to the company, which may increase or decrease the risk profile of the company. Such factors include the size of the company, pending lawsuits, concentration of customer base and dependence on key employees. Adjustments are entirely a matter of investor judgment and they vary from company to company. Cost of Debt Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt. If the company is not paying market rates, an appropriate market rate payable by the company should be estimated. As companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment. Therefore, the after-tax cost of debt is Rd (1 - corporate tax rate). Finally, Capital Structure The WACC is the weighted average of the cost of equity and the cost of debt based on the

proportion of debt and equity in the company's capital structure. The proportion of debt is represented by D/V, a ratio comparing the company's debt to the company's total value (equity + debt). The proportion of equity is represented by E/V, a ratio comparing the company's equity to the company's total value (equity + debt). The WACC is represented by the following formula: WACC = Rex E/V + Rd x (1 - corporate tax rate) x D/V. A company's WACC is a function of the mix between debt and equity and the cost of that debt and equity. On the one hand, in the past few years, falling interest rates have reduced the WACC of companies. On the other hand, corporate disasters like those at Enron and WorldCom have increased the perceived risk of equity investments. Be warned: the WACC formula seems easier to calculate than it really is. Rarely will two people derive the same WACC, and even if two people do reach the same WACC, all the other applied judgments and valuation methods will likely ensure that each has a different opinion regarding the components that comprise the company's value.

Widget Company WACC Returning to our example, let's suppose The Widget Company has a capital structure of 40% debt and 60% equity, with a tax rate of 30%. The borrowing rate (Rd) on the company's debt is 5%. The risk-free rate (Rf) is 5%, the beta is 1.3 and the risk premium (Rp) is 8%. The WACC comes to 10.64%. So, rounded up to the nearest percentage, the discount rate for The Widget Company would be 11% (see Figure 1).

WACC for The Widget Company Cost of Debt 0.40 [Rd x (1-.30)] + 0.40 [5.0 x 0.7)] + 0.40 [3.5] + 1.40 + WACC Rounded WACC Cost of Equity 0.60 [RF + b(RP)] 0.60 [5.0 + 1.3(8)] 0.60 [15.4] 9.24 10.64% 11%

Figure 1

In the next section of the tutorial, we'll do the final calculations to generate a fair value for the Widget Company. Next: DCF Analysis: Coming Up With A Fair Value

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By Ben McClure Contact Ben Now that we have calculated the discount rate for the Widget Company, it's time to do the final calculations to generate a fair value for the company's equity. Calculate the Terminal Value Having estimated the free cash flow produced over the forecast period, we need to come up with a reasonable idea of the value of the company's cash flows after that period - when the company has settled into middle-age and maturity. Remember, if we didn't include the value of long-term future cash flows, we would have to assume that the company stopped operating at the end of the five-year projection period. The trouble is that it gets more difficult to forecast cash flows over time. It's hard enough to forecast cash flows over just five years, never mind over the entire future life of a company. To make the task a little easier, we use a "terminal value" approach that involves making some assumptions about long-term cash flow growth. Gordon Growth Model There are several ways to estimate a terminal value of cash flows, but one well-worn method is to value the company as a perpetuity using the Gordon Growth Model. The model uses this formula:

Terminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate) (Discount Rate Long-Term Cash Flow Growth Rate)

The formula simplifies the practical problem of projecting cash flows far into the future. But keep in mind that the formula rests on the big assumption that the cash flow of the last projected year will stabilize and continue at the same rate forever. This is an average of the growth rates, not one expected to occur every year into perpetuity. Some growth will be higher or lower, but the expectation is that future growth will average the long-term growth assumption. Returning to the Widget Company, let's assume that the company's cash flows will grow in perpetuity by 4% per year. At first glance, 4% growth rate may seem low. But seen another way, 4% growth represents roughly double the 2% long-term rate of the U.S. economy into eternity. In the section on "Forecasting Free Cash Flows", we forecast free cash flow of $21.3 million for Year 5, the final or "terminal" year in our Widget Company projections. You will also recall that we calculated The Widget Company's discount rate as 11% (see "Calculating The Discount Rate"). We can now calculate the terminal value of the company using the Gordon Growth Model:

Exit Multiple Model Another way to determine a terminal value of cash flows is to use a multiplier of some income or cash flow measure, such as net income, net operating profit, EBITDA (earnings before interest, taxes, depreciation, and amortization), operating cash flow or free cash flow. The multiple is generally determined by looking at how comparable companies are valued by the market. Was there a recent sale of stock of a similar company? What is the standard industry valuation for a company at the same stage of maturity? In Year 5, the Widget Company is expected to produce free cash flow of $21.3M. Multiplying this by a projected price-to-free cash flow of 15 gives us a terminal value of $319.9M.

You will see that the terminal value can contribute a great deal to total value, so it is important to use an exit multiple that can be justified. One way to make the multiple more believable is to give estimates on the conservative side. Justifying a multiple of 15 with your figures would certainly be easier to justify than one at 20 or 25. Because it can be tricky to justify the multiple, this method isn't used as much as the Gordon Growth Model. Calculating Total Enterprise Value Now you have the following free cash flow projection for the Widget Company.

Year 1 Year 2 Year 3 Year 4 Year 5 $18.5M $21.3M $24.1M $19.9M $21.3M

To arrive at a total company value, or enterprise value (EV), we simply have to take the present value of the cash flows, divide them by the Widget Company's 11% discount rate and, finally, add up the results.

Therefore, the total enterprise value for The Widget Company is $265.3 million. Calculating the Fair Value of Equity But we are not finished yet - we cannot forget about debt. The Widget Company's $265.3M enterprise value includes the company's debt. As equity investors, we are interested in the value of the company's shares alone. To come up with a fair value of the company's equity, we must deduct its net debt from the value.

Let's say The Widget Company has $50M in net debt on its balance sheet. We subtract that $50M from the company's $265.3M enterprise value to get the equity value.

Fair Value of Widget Company Equity = Enterprise Value Debt Fair Value of Widget Company = $265.3M - $50M =$215.3M

So, by our calculations, the Widget Company's equity has a fair value of $215.3 million. That's it - the DCF valuation is complete. Having finished the DCF valuation, we can judge the merits of buying Widget Company shares. If we divide the fair value by the number of Widget Company shares outstanding, we get a fair value for the company's shares. If the shares are trading at a lower value than this, they could represent a buying opportunity for investors. If they are trading higher than the per share fair value, shareholders may want to consider selling Widget Company stock. You are familiar with the mechanics of DCF analysis and you have seen it applied to a practical example; now it's time to consider the strengths and weaknesses of this valuation tool. What makes DCF better than other valuation methods? What are its shortcomings? We answer those questions in the following section of this tutorial. Next: DCF Analysis: Pros & Cons Of DCF

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By Ben McClure Contact Ben Having worked our way through the mechanics of discounted cash flow analysis, it is worth our while to examine the method's strengths and weaknesses. There is a lot to like about the valuation tool, but there are also reasons to be cautious about it. Advantages Arguably the best reason to like DCF is that it produces the closest thing to an intrinsic

stock value. The alternatives to DCF are relative valuation measures, which use multiples to compare stocks within a sector. While relative valuation metrics such as priceearnings (P/E), EV/EBITDA and price-to-salesratios are fairly simple to calculate, they aren't very useful if an entire sector or market is over or undervalued. A carefully designed DCF, by contrast, should help investors steer clear of companies that look inexpensive against expensive peers. (To learn more, see Relative Valuation: Don't Get Trapped.) Unlike standard valuation tools such as the P/E ratio, DCF relies on free cash flows. For the most part, free cash flow is a trustworthy measure that cuts through much of the arbitrariness and "guesstimates" involved in reported earnings. Regardless of whether a cash outlay is counted as an expense or turned into an asset on the balance sheet, free cash flow tracks the money left over for investors. Best of all, you can also apply the DCF model as a sanity check. Instead of trying to come up with a fair value stock price, you can plug the company's current stock price into the DCF model and, working backwards, calculate how quickly the company would have to grow its cash flows to achieve the stock price. DCF analysis can help investors identify where the company's value is coming from and whether or not its current share price is justified. Disadvantages Although DCF analysis certainly has its merits, it also has its share of shortcomings. For starters, the DCF model is only as good as its input assumptions. Depending on what you believe about how a company will operate and how the market will unfold, DCF valuations can fluctuate wildly. If your inputs - free cash flow forecasts, discount rates and perpetuity growth rates - are wide of the mark, the fair value generated for the company won't be accurate, and it won't be useful when assessing stock prices. Following the "garbage in, garbage out" principle, if the inputs into the model are "garbage", then the output will be similar. DCF works best when there is a high degree of confidence about future cash flows. But things can get tricky when a company's operations lack what analysts call "visibility" - that is, when it's difficult to predict sales and cost trends with much certainty. While forecasting cash flows a few years into the future is hard enough, pushing results into eternity (which is a necessary input) is nearly impossible. The investor's ability to make good forward-looking projections is critical - and that's why DCF is susceptible to error.

Valuations are particularly sensitive to assumptions about the perpetuity growth rates and discount rates. Our Widget Company model assumed a cash flow perpetuity growth rate of 4%. Cut that growth to 3%, and the Widget Company's fair value falls from $215.3 million to $190.2 million; lift the growth to 5% and the value climbs to $248.7 million. Likewise, raising the 11% discount rate by 1% pushes the valuation down to $182.7 million, while a 1% drop boosts the Widget Company's value to $258.9 million. DCF analysis is a moving target that demands constant vigilance and modification. A DCF model is never built in stone. If the Widget Company delivers disappointing quarterly results, if its major customer files for bankruptcy, or if interest rates take a dramatic turn, you will need to adjust your inputs and assumptions. If any time expectations change, the fair value will change.

That's not the only problem. The model is not suited to short-term investing. DCF focuses on long-term value. Just because your DCF model produces a fair value of $215.3 million that does not mean that the company will trade for that any time soon. A well-crafted DCF may help you avoid buying into a bubble, but it may also make you miss short-term share price run-ups that can be profitable. Moreover, focusing too much on the DCF may cause you to overlook unusual opportunities. For example, Microsoft seemed very expensive back in 1995, but its ability to dominate the software market made it an industry powerhouse and an investor's dream soon after. DCF is a rigorous valuation approach that can focus your mind on the right issues, help you see the risk and help you separate winning stocks from losers. But bear in mind that while the DCF technique we've sketched out can help reduce uncertainty, it won't make it disappear. What's clear is that investors should be conservative about their inputs and should not resist changing them when needed. Aggressive assumptions can lead to inflated values and cause you to pay too much for a stock. The best way forward is to examine valuation from a variety of perspectives. If the company looks inexpensive from all of them, chances are better that you have found a bargain.

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By Ben McClure Contact Ben As you have seen, DCF analysis tries to work out the value of a company today, based on projections of how much money it will generate in the future. The basic idea is that the value of any company is the sum of the cash flows that it produces in the future, discounted to the present at an appropriate rate. In this tutorial, we have shown you the basic technique used to generate fair values for the stocks that you follow. But keep in mind that this is just one approach to doing DCF analysis; every analyst has his or her own theories on how it should be done. Although manually working your way through all the numbers in DCF analysis can be a time-consuming and tricky process at times, it's not impossible. Yes, using a DCF model probably entails a lot more work than relying on traditional valuation measures such as the P/E ratio, but we hope this step-by-step guide has shown you that it is worth the effort. DCF analysis treats a company as a business rather than just a ticker symbol and a stock price, and it requires you to think through all the factors that will affect the company's performance. What DCF analysis really gives you is an appreciation for what drives stock values. Here are some external resources that you may want to check out: Damodaran Online - Aswarth Damodaran, professor of finance at New York University's Stern School of Business, has created an excellent website devoted to valuation techniques.

He offers numerous DCF models set up in Excel spreadsheets, and he gives details on the intricacies of the models. Valuing Intel: A Strange Tale Of Analysts And Announcements - Bradford Cornell, professor at UCLA's Anderson Graduate School of Management, has produced an excellent DCF analysis that assesses market and stock analysts' reactions to an Intel Corp. earnings announcement.

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The purpose of the Discounted Cash Flow (DCF) valuation is to find the sum of the future cash flow of the business and discount it back to a present value. I use the F Wall Street method of valuing a business along with some tweaks here and there to suit my tastes in the free and best valuation spreadsheets you can find on this site. The advantage of this method is that it requires the investor to think about the stock as a business and analyze its cash flow rather than earnings. The first and foremost reason a business exists is to make money where money = cash, not earnings. Since cash is what a business needs in order to maintain and grow its operations, its only right to consider the possibility of its future cash growth rather than earnings growth.

The disadvantage is that DCF is not suitable for start ups, growth companies or capital intensive companies where the cash flow cannot be accurately determined. The error of prediction and assumptions must also be dealt with in the DCF, which we cover with margin of safety. Ill go through the many assumptions to consider with a DCF and how to effectively use it with the stock valuation calculator

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From Wikipedia, the free encyclopedia

This article needs additional citations for verification. Please help improve this article byadding citations to reliable sources. Unsourced material may be challenged and removed.(January 2010)

Spreadsheet uses Free cash flows to estimate stock's Fair Value and measure the sensibility of WACC and Perpetual growth

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question. Present value may also be expressed as a number of years' purchase of the future undiscounted annual cash flows expected to arise. Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite processtaking cash flows and a price and inferring a discount rateis called the yield.

Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management and patent valuation.

Contents

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4 Example DCF 5 Methods of appraisal of a company or project 6 Shortcomings 7 See also 8 References 9 External links 10 Further reading

Discount rate[edit]

Main article: Discounting The most widely used method of discounting is exponential discounting, which values future cash flows as "how much money would have to be invested currently, at a given rate of return, to yield the cash flow in future." Other methods of discounting, such ashyperbolic discounting, are studied in academia and said to reflect intuitive decision-making, but are not generally used in industry. The discount rate used is generally the appropriate weighted average cost of capital (WACC), that reflects the risk of the cashflows. The discount rate reflects two things: 1. Time value of money (risk-free rate) according to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay 2. Risk premium reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all

History[edit]

Discounted cash flow calculations have been used in some form since money was first lent at interest in ancient times. As a method of asset valuation it has often been opposed to accounting book value, which is based on the amount paid for the asset. Following the stock market crash of 1929, discounted cash flow analysis gained popularity as a valuation method for stocks. Irving Fisher in his 1930 book The Theory of Interest and John Burr Williams's 1938 text The Theory of Investment Value first formally expressed the DCF method in modern economic terms.

Mathematics[edit]

Discounted cash flows[edit]

The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.

Thus the discounted present value (for one cash flow in one future period) is expressed as:

where

DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt;

FV is the nominal value of a cash flow amount in a future period; i is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full;

d is the discount rate, which is i/(1+i), i.e., the interest rate expressed as a deduction at the beginning of the year instead of an addition at the end of the year;

Where multiple cash flows in multiple time periods are discounted, it is necessary to sum them as follows:

for each future cash flow (FV) at any time period (t) in years from the present time, summed over all time periods. The sum can then be used as a net present value figure. If the amount to be paid at time 0 (now) for all the future cash flows is known, then that amount can be substituted for DPV and the equation can be solved for i, that is the internal rate of return. All the above assumes that the interest rate remains constant throughout the whole period.

For continuous cash flows, the summation in the above formula is replaced by an integration:

where FV(t) is now the rate of cash flow, and = log(1+i). DF (r/1+r)-1

Example DCF[edit]

To show how discounted cash flow analysis is performed, consider the following simplified example.

John Doe buys a house for $100,000. Three years later, he expects to be able to sell this house for $150,000.

Simple subtraction suggests that the value of his profit on such a transaction would be $150,000 $100,000 = $50,000, or 50%. If that $50,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 14.5%. Looking at those figures, he might be justified in thinking that the purchase looked like a good idea. 1.1453 x 100000 = 150000 approximately. However, since three years have passed between the purchase and the sale, any cash flow from the sale must be discounted accordingly. At the time John Doe buys the house, the 3-year US Treasury Note rate is 5% per annum. Treasury Notes are generally considered to be inherently less risky than real estate, since the value of the Note is guaranteed by the US Government and there is aliquid market for the purchase and sale of T-Notes. If he hadn't put his money into buying the house, he could have invested it in the relatively safe T-Notes instead. This 5% per annum can therefore be regarded as the risk-free interest rate for the relevant period (3 years).

Using the DPV formula above (FV=$150,000, i=0.05, n=3), that means that the value of $150,000 received in three years actually has apresent value of $129,576 (rounded off). In other words we would need to invest $129,576 in a T-Bond now to get $150,000 in 3 years almost risk free. This is a quantitative way of showing that money in the future is not as valuable as money in the present ($150,000 in 3 years isn't worth the same as $150,000 now; it is worth $129,576 now). Subtracting the purchase price of the house ($100,000) from the present value results in the net present value of the whole transaction, which would be $29,576 or a little more than 29% of the purchase price. Another way of looking at the deal as the excess return achieved (over the risk-free rate) is (114.5 - 105)/(100 + 5) or approximately 9.0% (still very respectable). But what about risk? We assume that the $150,000 is John's best estimate of the sale price that he will be able to achieve in 3 years time (after deducting all expenses, of course). There is of course a lot of uncertainty about house prices, and the outcome may end up higher or lower than this estimate. (The house John is buying is in a "good neighborhood," but market values have been rising quite a lot lately and the real estate market analysts in the media are talking about a slow-down and higher interest rates. There is a probability that John might not be able to get the full $150,000 he is expecting in three years due to a slowing of price appreciation, or that loss of liquidity in the real estate market might make it very hard for him to sell at all.) Under normal circumstances, people entering into such transactions are risk-averse, that is to say that they are prepared to accept a lower expected return for the sake of avoiding risk. See Capital asset pricing model for a further discussion of this. For the sake of the example (and this is a gross simplification), let's assume that he values this particular risk at 5% per annum (we could perform a more precise probabilistic analysis of the risk, but that is beyond the scope of this article). Therefore, allowing for this risk, his expected return is now 9.0% per annum (the arithmetic is the same as above). And the excess return over the risk-free rate is now (109 - 105)/(100 + 5) which comes to approximately 3.8% per annum. That return rate may seem low, but it is still positive after all of our discounting, suggesting that the investment decision is probably a good one: it produces enough

profit to compensate for tying up capital and incurring risk with a little extra left over. When investors and managers perform DCF analysis, the important thing is that the net present value of the decision after discounting all future cash flows at least be positive (more than zero). If it is negative, that means that the investment decision would actually lose money even if it appears to generate a nominal profit. For instance, if the expected sale price of John Doe's house in the example above was not $150,000 in three years, but $130,000 in three years or $150,000 in five years, then on the above assumptions buying the house would actually cause John to lose money in presentvalue terms (about $3,000 in the first case, and about $8,000 in the second). Similarly, if the house was located in an undesirable neighborhood and the Federal Reserve Bank was about to raise interest rates by five percentage points, then the risk factor would be a lot higher than 5%: it might not be possible for him to predict a profit in discounted terms even if he thinks he could sell the house for $200,000 in three years. In this example, only one future cash flow was considered. For a decision which generates multiple cash flows in multiple time periods, all the cash flows must be discounted and then summed into a single net present value.

This is necessarily a simple treatment of a complex subject: more detail is beyond the scope of this article. For these valuation purposes, a number of different DCF methods are distinguished today, some of which are outlined below. The details are likely to vary depending on the capital structure of the company. However the assumptions used in the appraisal (especially the equity discount rate and the projection of the cash flows to be achieved) are likely to be at least as important as the precise model used. Both the income stream selected and the associated cost of capital model determine the valuation result obtained with each method. This is one reason these valuation methods are formally referred to as the Discounted Future Economic Income methods.

Equity-Approach

Discount the cash flows available to the holders of equity capital, after allowing for cost of servicing debt capital Advantages: Makes explicit allowance for the cost of debt capital

Entity-Approach:

Discount the cash flows before allowing for the debt capital (but allowing for the tax relief obtained on the debt capital) Advantages: Simpler to apply if a specific project is being valued which does not have earmarked debt capital finance Disadvantages: Requires judgement on choice of discount rate; no explicit allowance for cost of debt capital, which may be much higher than a "risk-free" rate

Weighted average cost of capital approach (WACC)

Derive a weighted cost of the capital obtained from the various sources and use that discount rate to discount the cash flows from the project Advantages: Overcomes the requirement for debt capital finance to be earmarked to particular projects Disadvantages: Care must be exercised in the selection of the appropriate income stream. The net cash flow to total invested capital is the generally accepted choice.

Total cash flow approach (TCF)[clarification needed]

This distinction illustrates that the Discounted Cash Flow method can be used to determine the value of various business ownership interests. These can include equity or debt holders. Alternatively, the method can be used to value the company based on the value of total invested capital. In each case, the differences lie in the choice of the income stream and discount rate. For example, the net cash flow to total invested capital and WACC are appropriate when valuing a company based on the market value of all invested capital.[1]

Shortcomings[edit]

Commercial banks have widely used discounted cash flow as a method of valuing commercial real estate construction projects. This practice has two substantial shortcomings. 1) The discount rate assumption relies on the market for competing investments at the time of the analysis, which would likely change, perhaps dramatically,

over time, and 2) straight line assumptions about income increasing over ten years are generally based upon historic increases in market rent but never factors in the cyclical nature of many real estate markets. Most loans are made during boom real estate markets and these markets usually last fewer than ten years. Using DCF to analyze commercial real estate during any but the early years of a boom market will lead to overvaluation of the asset[citation needed]. Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the principle "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on involves calculating the period of time likely to recoup the initial outlay.[2]

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BY Jonas Elmerraji|10/18/07 - 02:58 PM EDT

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NEW YORK (TheStreet) -- Discounted cash flows are used by pros in the finance world all the time to figure out what an investment is actually worth. And while calculating discounted cash flows can be an involved process, it can also be a lucrative one as well. Here's a look at DCF valuation and how you can use it on your personal investments and finances.

Think of discounted cash flows this way: they're a way of taking a payoff from an investment in the future, and putting it in terms of today's money. Discounted cash flows take into account the time value of money -- the fact that one dollar 10 years from now is worth less than $1 today. If I loan that dollar to someone, I'm costing myself all the interest or gains that I would earn if I saved or invested it. I'm also pitting 10 years of inflation against my dollar's buying power. What that means is that when all is said and done, my dollar's only worth around 51 cents (I'll get to how I calculated that in a bit), which means that I'm losing about half of my money.

Discounted cash flows take these factors into account to calculate what a reasonable valuation is today for a company's success years down the road.

DCFs are omnipresent in the finance world -- they're used by everybody, from analysts to portfolio managers -- even Warren Buffett is known to make decisions based on discounted cash flow calculations. But why? Discounted cash flows give investors a better picture of a company's value today because they account for what it might be worth tomorrow. You probably wouldn't buy a car without knowing what it's worth, so why would a stock be any different? Having a more relatable dollar value in front of you can help you make better-informed investment decisions. Discounting can actually be used for more than just cash flows. Historically, cash flows have been discounted because they represent cold hard tangible assets. They're also devoid of income statement items like depreciation expenses that affect a company's income without affecting the amount of money the company has.

Word to the wise: discounting cash flows involves math -- and a fair amount at that. One of the most basic formulas for discounted cash flows is a present value calculation:

The discount rate mentioned in the formula is the opportunity cost (time value of money) -- in the case of my dollar loan, it's the inflation and lost interest that made my dollar worth so much less 10 years after I lent it. In the case of stocks, the discount rate is typically the cost of the company's capital. It gets a little trickier for multiple periods. But never fear, for those of us who aren't "mathemagicians," there are a plethora of online calculators (some of which you'll find in the homework section of this article) that allow you to drop in your numbers in order to calculate the present value of your cash flows.

Discounting cash flows can be tricky. Remember, you're using estimates here for future numbers, so "bad" or unreasonable estimates can mean worthless numbers. According to Jim Troyer, a Principal at The Vanguard Group, these future projections are one of the biggest snags for investors new to DCF. "There are two main things people do," Troyer says, "make assumptions at random, and project the past into the future." Troyer describes these mistakes as "blind trend projection" and "inconsistent assumptions."

Troyer warns investors: "Most firms can't grow faster than the economy forever. When you use discounted cash flows, it's important not to project too strong of growth rate too far out. A very small change in something like the discount rate can have a huge affect on present value." It's also important to remember that numbers aren't static -- they change over time. Don't put too much stock in DCF valuations that might be out of date. A perfectly valid valuation made three years ago might not be at all in line with a company's present day value. DCF valuations represent long-term projections, so don't fall into the trap of thinking that just because a company is supposedly overvalued it isn't a good short-term investment. Discounting cash flows mainly deals with assessing a company's fundamentals and doesn't take into account the technical issues that might send a "bad" stock's price soaring in the short run.

The methods used for discounting cash flows can vary depending on the type of investment you're trying to value. Here are a few popular uses for DCF. Bonds. One of the central elements of bond valuation is the use of discounted cash flows. With the bonds, though, the numbers are a lot more concrete. Troyer says, "The bond market is essentially a giant DCF engine. It's the same way with stocks, but the numbers aren't as scientific." Why? With a bond, variables like number of periods, future cash flow, and discount rate (coupon in the case of a bond), are all given and don't change. Despite the fact that the discounting of bond cash flows are generally factored into the bond's pricing, if you're into bonds, then understanding DCF is a must. Stocks. Stocks are an area where DCF is a popular tool. The stock market is also a place where poorly thought-out DCFs can lose big money. Stocks have added elements of confusion when it comes to DCF since they don't have the static numbers that bonds do. Because of this, calculating discounted cash flows for equities adds an extra element of risk that's actually taken into account in more complex DCF equations. Real estate. Real estate is another area where DCF calculations are popular. If you're a "flipper" (someone who buys properties to quickly fix up and sell for a profit), then you're doing yourself a major disservice if DCF doesn't come into your decision-making process.

Let's go back to my $1 loan. How did I determine that 10 years from now I'd only have 51 cents? Because my friend will be repaying me with $1 in 10 years, the future cash flow to me is just $1. To determine the discount rate (or rate of return, using a future value calculator), I had to consider two things: inflation and the interest I'd be missing out on. With U.S. inflation currently around 2.5%

(according to the C.I.A. World Factbook), and my savings account paying out 4.5%, I'm missing out on 7% annually. That's my discount rate. We'll compound annually for simplicity's sake, which would mean 10 periods. So, taking the equation I showed you earlier, my equation will look something like this:

Granted, this is a very simple example. If you want to learn more complex DCF computations, make sure to check out the homework at the end of this article. DCF valuation can be a fantastic tool to determine what an investment is worth in today's money. But that doesn't mean that it's without its pitfalls -- bad assumptions and projections can break the benefits of calculating DCF. When used correctly, discounted cash flows can really add a lot to your investment decision process.

DCF Homework

So do you want to get Buffett-like analysis skills? Here are two activities that can help you hone your ability to discount cash flows. 1. Explore Professor Damodaran's Web site. If you want to learn more advanced concepts and formulas about discounted cash flows, visit the Web site of Professor Aswath Damodaran at the NYU Stern School of Business. His site on valuation, corporate finance and investment offers lecture notes, tutorials, sample problems and worksheets that can help enhance your valuation abilities. 2. Practice with online calculators. Go to an online DCF calculator and practice making your own projections for real stocks with historical data. How do your estimates hold up? Here are a few online calculators of varying complexity:

Present Value and Future Value (University of Illinois at Chicago) Various Financial Calculation Tips for Microsoft Excel (Eastern Illinois University) Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.

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Before even thinking about valuing stocks using discounted cash flows, first see how this method fits into the possible investing strategies discussed on the Big Picture Strategy page. This methodology for valuing projects is very powerful. It has three basic inputs; the cash flow dollars, the timing of those cash flows and the rate of return demanded. But there are more than a few problems when trying to use it for valuing stocks.

The model presumes receipt of, and benefit from, all the cash flows by the investor himself. That will be true of the stock's purchase and sale price and its dividends. But what about companies which pay no (or small) dividends? Then the eventual sale price becomes the dominant factor in the stock's valuation. When the current value is derived from the future resale price, any assumptions about the valuation at the later date self-justify the current value. If the current value depends on discounted cash flows, then that future sale price will also depend on discounted cash flows. So any analysis would have to go far into the future, until the discount rate makes those cash flows immaterial. That analysis is never done, with any valuation methods using cash flows.

The model has no inputs for dilutions of ownership percentages. It is never calculated on a 'per-share' basis. When shares are issued and bought-back, or when options are used for compensation, the stock owner's percentage ownership of the whole changes.

The model has no inputs for non-cash barter transactions, e.g. DRIPs, or shares-for-buyouts. As this methodology has gained popularity, so too

management has finessed analysts by hiding the company's problems in these ignored transactions.

There remains the huge problem of defining exactly "what" cash flow. For a directly owned project, all cash generated is under the control of owners and available to them (the total changes in cash = the first column of the diagram below). But shareholders have no control over a company's cash - either the total change in cash or possibly some subset, of a subset, of a subset, of that total (working your way to the right of the diagram). What definition of 'cash' should be considered 'as if' under the control of shareholders?

Discounted Dividends

the Discounted Dividend model (the Gordon Growth formula). The formula is derived mathematically by summing the present value (discounted value) of each future year's dividend. But is it really a discounted cash flow model? No. It misses the point. The idea behind calculating the Net Present Value of cash flows requires an active estimate of each future cash flow - its size and timing. In contrast, the discounted dividend models simply assumes the cash flows to be equal (adjusted for growth) forever. At best, an allowance is made for one change (possibly two) in the future. What is being accomplished by the calculation is not 'discounting cash flows'. The model effectively 'capitalizes' the yield. There is a qualitative difference between the two systems. E.g. you find a perpetual preferred share's value by 'capitalizing' its income - by dividing the dividend $$ by your required return. E.g. you capitalize real estate's profits by dividing the operating cash flow by your required Cap Rate. E.g. you find a stock's value by capitalizing its earnings dividing earnings by your required earnings yield (using P/E metrics). The Gordon equation finds the security's value necessary to make the sum of the dividend yield plus growth equal the investor's required rate of return. The equation can be derived without any discounting at all. It 'capitalizes' the dividends.

There is another valuation system that may be labeled as 'discounted cash flows', but it is really only a 'capitalizing' model. Instead of capitalizing dividends or earnings, it

capitalizes some defined measure of 'cash flow'. Cash flow is divided by some appropriate required return (equivalent to the earning yield, so let's call it 'cash yield') to determine a security's value. This is what has happened when you hear the 'experts' saying "It is trading at just 4 times cash flow." This multiple of Price to CashFlow (P/C) is equivalent to the P/E multiple. But there are many problems.

No matter what measure of cash flow you use, the flow varies widely year by year. Yet when you capitalize a particular year's cash flow you are presuming it is 'normal' and will continue forever (with presumed growth).

No matter what ACTUAL cash flow you measure, it will always need adjustments before it can be considered 'normal'. A lot of those adjustments effectively recreate accrual accounting.

Poor cash flow (however measured) in one year may well be because great things are happening. Expansion opportunities require investment. But capitalizing cash flow would value the company lower, not higher.

Price/Cash quotes, (eg) 4 times cash, or 8 times cash, are meaningless numbers. Is 8 good or bad. 4 seems much cheaper but is it so cheap as to raise red flags? Why are Oil and Gas companies considered appropriately valued at 5 time cash flow, while Industrials are valued at 15 times cash flow?

Most of us are familiar with P/E multiples. We know the historical averages and extremes. We know what values are appropriate for different industries or growth rates. But none of that is true for P/C. Should we consider the P/C in comparison to the P/E, or in comparison between stocks? Is 'half-the-PE' appropriate? What are we supposed to DO with the

number?

How do you evaluate the company with a high P/C only because it has chosen to (eg) lease equipment instead of buying it?

The cash flow $$ used must be defined somehow that makes sense. You are familiar with valuations based on earnings and dividends. But the cash flow definitions most always used are FAR larger than earnings or dividends. Arguments can be made for and against the inclusion of most all the sets and sub-set of cash shown in the diagram above. Free Cash Flow (FCF) sounds as if it is the metric to use, but how exactly is it defined? You cannot see it in the diagram above. Its failings are discussed on the Cash Truths That Aren't page.

The true discounted cash flow model is necessarily made of two parts. For the first period of years the company's cash payments and receipts are modeled year by year, line item by line item. The yearly net cash is discounted back to the present. After that a steady sustainable rate of growth is presumed for the long run. The stock's presumed value at that time, using simple P/E metrics usually, is also discounted back to the present. One model is presented by Aswath Damodaran on this spreadsheet. His book detailing the method is published online from this directory.

For each year of the foreseeable future the expected net cash increase/decrease is calculated. It reflects the left

o

Net Income (Warning! other models start from other points and will therefore have other adjusting entries.)

o o

less increases to working capital plus new financing received net of debt principal repaid less purchases of fixed assets for growth and replacement plus (to reverse out) depreciation and amortization

Each year's change in cash is discounted back to the present. The value of the stock at the end of the foreseeable phase is derived using the more basic P/E or Discounted Dividend models. This is also discounted to the present. So the model still has the problem of deriving a valuation for the company at the end of the period where discounted cash flows are measured. It really only delays the problem of valuation. A huge amount of work is involved in modeling the first period, but that level of exactitude is destroyed by the generalizations involve in the valuation at the end of that period.

Damodaran's CashFlow (unlike most all other's) is predicted to be less than the accountants' earnings (Net Income) because he includes the costs of growth investments. -

Increases to Working Capital are necessary for growth, even if the growth is due only to inflation. It is most common to see the current quarter/year's change in current assets used as if it is a 'normalized' value. In fact there are large swings from quarter to quarter, year to year, even though over the longer term the funding level is stable for a given level of sales.

the current portion of long-term-debt and bank debt. It is cash you are trying to measure and the debt is handled separately.

Net Financing Received equals the net excess of new debt proceeds over any repayments. Companies most often keep their debt-to-equity ratios stable, so growth is financed by a combination of retained earnings and net new debt. Too often investors subtract the required debt repayments from CFFO in their calculation of FCF, ignoring new debt. This ignores the reality that company's debt balance is rarely reduced. It is replaced. With operating growth, debt will probably grow too.

Remember to add the higher interest payments that result from additional debt in the year-by-year cash flow modeled.

Damodaran reduces his CashFlow by the cost of long-life assets (showing in the left column of the diagram above asLong-Term Investments). Notice how his estimates are LARGER than the depreciation booked. You will almost never see an analyst making that assumption.

Companies also grow by paying for Goodwill and Intangible assets. You could argue that these expenses should be included in the cost of new fixed assets. But in reality most often these are paid for by issuing additional share capital of the company. There is no cash flow. Since the model does not reflect any changes to the percentage ownership of a share, it seem appropriate to ignore both these sides of the transaction.

Depreciation and amortization are correctly added back to Net Income in everyone's calculation of cash flows. Their

Conclusion

While discounted cash flow analysis is an excellent methodology for evaluating projects over which you have complete control, for valuing common stock it is full of problems. What measure of cash flow do you use: Earnings, Dividends, CFFO or Free Cash Flow? Retail investors must appreciate that correctly derived Free Cash Flow involves a lot of time and industry knowledge, which they probably do not have. Maybe using the traditional valuation metrics are not a bad idea.

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You are here: Home / Investing / How to Value Stocks using DCFand the Dangers of Doing So

POSTED ON SEPTEMBER 10, 2012 // 66 COMMENTS

Warren Buffett wrote in his 1992 letter to shareholders of Berkshire Hathaway In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate that can be expected to occur during the remaining life of the asset. What Buffett defines here is essentially what we know as the discounted cash flow or DCF, a key method to calculate intrinsic value of companies. The interesting thing to note here is that no one knows whether Buffett has ever used DCF himself! Even Buffetts business partner and alter ego Charlie Munger has occasionally said that he has never seen Buffett doing any DCF calculations. In fact, this is what Buffett wrote in his 2002 letter Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investments are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we normally will not talk about our investment ideas. Anyways, despite his secretiveness, Buffett has been vocal about the importance of DCF several times in the past. But if you were to believe a majority of security analysts out there, they will tell you to simply avoid DCF. The reason they give is that DCF is dependent on 5-10 years of future cash flows, predicting which is highly uncertain. So they use relative valuation multiples like price to earnings, price to book value, or EV/EBITDA (which are also based on predictions!). But you must recognize the simple fact that multiples are not valuation. In fact, multiples are simply shorthand for the intrinsic valuation process, which must generally be based on the DCF method. You must never confuse the two multiple based valuation and intrinsic valuation.

Of course, doing a P/E based valuation of stock can save you a lot of time and hard work (and thats why most analysts use this). But it will be merely a case of garbage in garbage out. In fact, the simplicity of such ratios is a sign of inaccuracy, not accuracy. As Keynes said, It is better to be vaguely right than precisely wrong.

If you were to go through the DCF calculation excel, there are three key variables you need to calculate the DCF value of a company:

1. Estimates of growth in future free cash flows (FCF): Growth in FCF over say the next 10 years, using last 3 years average FCF as the starting point. (Click here to see the calculation of FCF from a companys cash flow statement) 2. Terminal growth rate: Rate of growth in FCF after the 10th year and till infinity. 3. Discount rate: Rate at which the future cash flows must be discounted to bring them to present value.

Now there are three key issues that arise with these variables: 1. What growth rate to assume for future FCF estimates? 2. What discount rate to assume? 3. What terminal growth rate to assume? Let me help you with how do I answer these questions for calculating DCF valuations myself.

As an analyst, I always found it difficult to predict growth rate in volumes, sales and profits. But I still tried to do that after all, I was paid to predict the future!

However, as Ive realised over the years, trying to find a perfect answer to the question What growth rate to assume? is like trying to find a perfect couple. None exist! Given this limitation of trying to predict the future, Ive changed my way of analysis to value stocks based on the present data rather than what will happen in the future. Thats why I now dont try be accurate with my FCF growth estimates. I just try to be reasonable and use common sense. For most stocks, I generally perform a 10-year 2-stage DCF analysis. What this means is that I assume a particular growth rate for the first five years of my FCF calculations (as you can see in my DCF excel), and then another number for the next five years. I rarely go above 15% annual growth rate for the first five years, and 8% for the next five. The best practice is to keep growth rates as low as possible. If the company looks undervalued with just 5% annual growth in FCF over the next 10 years, you have more upside than downside. The higher you set the growth rate, the higher you set up the downside potential. To repeat, while assuming FCF growth rate for the future, just be reasonable and use common sense. A caveat dont take cues from the past as the past performance is rarely repeated in the future.

In simple words, discount rate is the rate at which you must discount the future cash flows (as estimated using above growth assumptions) to the present value. Why present value? Because we are trying to compare the companys intrinsic value with its stock price now.in the present. Just to help with an example, what price would you pay for an investment today if company ABCs future cash flow is worth Rs 1,000 after 1 year?

If the discount rate is 5%, you must pay Rs 952 now (1000/1.05). If the discount rate is 10%, you must pay Rs 909 now (1000/1.1).

If the discount rate is 15%, you must pay Rs 870 now (1000/1.15). In other words, the higher the discount rate you assume, the lower you must pay for the stock as of now.

Finance textbooks and experts would tell you to use Capital Asset Pricing Model (CAPM) to calculate discount rate. I used CAPM myself to arrive at discount rates in the past. However, if you are worried what CAPM is, dont be because you can avoid knowing about it and still live happily ever after.like I am living. Look at discount rate as the annual rate of return you want to earn from the stock. In other words, if you are looking to invest in a business that has comparatively higher (business) risk than other businesses (like in case of most mid and small cap stocks), you may want to earn a 15% annual return from it. For valuing such businesses, take 15% as the discount rate. In case of relatively safer businesses (think Infosys, HUL, Colgate), earning around 1012% annual return over the long term is a good expectation (because these businesses will also provide some stability to your portfolio during bad times). For valuing such businesses, take 10-12% as the discount rate. Better still, assume a constant discount rate for all companies. I am gradually turning to this model of taking a constant 15% discount rate for all kind of businesses (safe or risky). But this way, how would you adjust for the risk in each business? you may ask. Simple adjust the risk in FCF growth estimates. That is where the real risk lies, right?

As I mentioned above, I do a 10-year FCF calculation for arriving at a stocks DCF valuation. But the companies Im valuing wont cease to exist after 10 year. Some will survive for 10 more years, some for 20 years, and very few for 50 years. That is where the concept of terminal value (or the value after 10th year and till eternity) comes into picture. The terminal value I generally assume lies between 0% and 2%. Assuming higher terminal value (>3-4%) is like assuming the company to grow bigger than the world economy in the infinity, which isnt possible. So the idea is to keep it as low as possible. Best to keep it at 0%.

No sir! Even after being reasonable and using common sense in assuming FCF growth rate, terminal growth rate and discount rate, there is 0% guarantee that you will arrive at a perfect intrinsic value using DCF (or for that matter, using any intrinsic value method). Believe me, however reasonable, realistic, rational (whatever you may want to call it) you get in calculating intrinsic values, you are bound to go wrong. This is for the simple reason that you are still trying to predict the futurewhich is unpredictable. Now what to do?

Valuation is an imprecise art (yes, however smart you may think you are!). Also, the future is inherently unpredictable. Thus, its important to bring in the most-important investing concept of margin of safety into the picture. This is what Graham wrote about margin of safety in The Intelligent Investor

Confronted with the challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. Margin of safety is simply the discount factor that you use with your intrinsic value calculation. So if you arrive at an intrinsic value of Rs 100 for a stock that trades at Rs 80, you might think that you have found a bargain. But what if your intrinsic value calculation is wrong? Yes, it will be wrong, at least 100% of the times! Thus, you will do yourself a world of good by buying the stock only at say 50% discount to your intrinsic value calculation, or around Rs 50.

Now when you bring your intrinsic value assumption down to Rs 50 by giving a 50% discount to the original calculated value of Rs 100, dont think that you are trying to be ultra-conservative. What you are doing is providing yourself protection against:

1. Bad luck

2. Bad timing, and 3. Bad judgment. As simple as that! Margin of safety was, and will always be, the bedrock of value investing. You cant ignore this at any costor it will turn out to be a costly affair!

The DCF model can provide a useful valuation estimate if you follows these simple principles:

Invest in companies with sustainable competitive advantage. Do the hard work of analyzing past financial statements (over at least a 10-year period).

Use conservative assumptions of FCF growth of around 10-15%, terminal growth rate of 0-2%, and discount rate of 10-15%.

Use margin of safety to protect against bad luck, bad timing, and bad judgment. Be honest by not modifying your original assumptions just because you like the

Most of you must have not heard of the concept of reverse DCF. Dont worry, its not that complex a subject that the name might suggest! You do a reverse DCF by reversing just one assumption in your original DCF calculation the FCF growth rates.

The aim of reverse DCF is to get the intrinsic value to match the stocks current price to find out whats the FCF growth estimates the stock market is pricing in the stock. Lets understand this with an example. Colgates current stock price is around Rs 1,230. However, assuming FCF growth rates of 10% (for 1-5 years) and 8% (for 6-10 years), we arrive at an intrinsic value of Rs 398. Now, we need to tweak the FCF growth rates in such a way, that this Rs 398 rises to around the current stock price of Rs 1,230. Just try that on your own calculations will show that when you raise the FCF growth rate to 26% for both the 5-year periods, the stocks intrinsic value will rise to Rs 1,233or almost near the current price. What this indicates is that the stock market is currently pricing Colgate at a level that is justified only when the company can grow its next 10-years FCF at an average annual rate of 26%! Now you need to answer whether such a long-term growth rate is realistic and achievable. Or whether the market has irrational expectations from Colgates business. Just for your information, Colgate has grown its FCF at an average annual rate of 16% over the past 8 years. So a 26% growth rate over the next 10 years really looks on the higher side. But as an investor, you must take a call on that! Thats all I have to discuss on the subject of DCF as of now. I would like to leave you with the link to a very good resource The Dangers of DCF written by James Montier in 2008. Finally, an important quote from a noted statistics professor, George E P Box All models are wrong; some are useful. So learn about DCF, use it, but expect to be wrong! All the best!

Great Stocks are Bad Investments for the Long Term 10 Stocks Im Watchingand Waiting to Buy Does Monetary Policy Really Impact Stock Prices? 10 Stocks I Would Want to Leave for My Grandchildren Should I Buy Stocks? Should I Wait?

FILED UNDER: INVESTING //

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