In our search for the best way to evaluate a company, we look at intrinsic value formulas to help us determine a fair price for a company. Using a discounted cash flow evaluation is one of the ways we can do this.
Accounting scandals and manipulations of financial earnings have given a rise to the importance of analyzing free cash flows. These numbers are much more difficult to “fudge” and lead to a truer value of the company.
Use of this formula will also give you much greater insight into the company. You will get a better understanding of its growth in operating earnings, capital efficiency, the capital structure of the balance sheet, the cost of the equity and debt, and the expected length of the growth of the company.
Another advantage is this formula is less likely to manipulated by dishonest accounting practices
We are going to take a look at this formula today and try to break it down and make it as easy to understand as we can. I am not going to lie to you there will be math involved but it is not difficult math.
In the business of finding the best intrinsic value for a company, we will be required from time to time to utilize math to find that intrinsic value.
So what is a discounted cash flow analysis?
According to Investopedia
“DCF analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.”
What does all that mean?
Simply to estimate the money you would receive from an investment while adjusting the time value of money.
The reason you do this is the value of the dollar today is not what it will be worth in the future. It could be more or it could be less. So to try to adjust for that we use the discounted cash flow model or formula to help us find the closest intrinsic value we can find.
The discounted cash flow formula is powerful, but it can be flawed. Remember that it is just a mathematical tool to be used to find an intrinsic value.
You should never buy a company based on this value alone.
It is only as good as the information you put into it. As my music teacher used to say to me. “Garbage in, garbage out.” Small changes or errors in our calculations can have a huge impact on our value.This is why we don’t base a buying decision on just one formula. Important though it may be.
Last week we discussed the intrinsic value formula that was created by Benjamin Graham. This was a much easier, simpler way to calculate an intrinsic value of a company. The look at discounted cash flows will give us another tool in our effort to find the most accurate intrinsic value of a company we are looking to buy.
There are many different variations of formulas to arrive at an intrinsic value. The Ben Graham formula is one of them and today’s formula, the discounted cash flow is considered a variation of that effort as well.
These are the two most commonly used formulas, but there are others that we may discuss further down the road.
Ok, let’s start.
6 Steps to Find an Intrinsic Value of a Stock Utilizing a Discounted Cash Flow Formula
There are six steps along this path to find the intrinsic value of a company using the discounted cash flow formula. We will take a look at each one and break them down so you can follow along.
For this example, we are going to use a company that we analyzed last week so we can compare our results later.
The steps we will use will be as follows.
- Locate all the required financial data
- Calculate the discount rate and use it to discount the future value of the business
- Perform a discounted free cash flow (DCF) analysis
- Calculate the company’s net present value (NPV)
- Calculate the company’s terminal value (TV)
- Combine the net present value and the terminal value and come up with the company’s intrinsic value
Sounds simple huh? It is and you can do this. I will be here to help you along the way.
Step 1: Find all the necessary financial information
Before we dive into this we are going to need to locate all the necessary numbers to fill into our formulas as we go along. And then it’s just a matter of plugging them in.
For our calculations, there are 14 financial figures we are going to need to assemble before we can calculate our intrinsic value.
- Current Share Price: Simple, find the current market price of the company
- Shares Outstanding: Again, pretty simple. Find the total number of shares that are issued and currently held by the company’s shareholders.
- Free Cash Flow: This number represents the company’s capacity for generating free cash flow, which can be used for future expansion, paying down debt, and increasing shareholder value with buybacks or dividends.
- Long-term Growth Rate: the expected rate at which the company will grow
- Business Tax Rate: the business income tax paid to the government.
- Business Interest Rate: the effective rate that the company is charged for its loans and any borrowing.
- Terminal Growth Rate: The rate that the company is expected to grow at after our cash flow projection period. We’ll use the country’s GDP growth rate as the Terminal Growth Rate
- Market Value of Debt: the total dollar market value of a company’s short-term and long-term debt.
- Market Value of Equity: otherwise known as the market cap. The total dollar market value of a company’s outstanding shares.
- Stock Beta: Beta is a measure of how much the price of a company’s stock tends to fluctuate
- Risk-Free Rate: the minimum rate of return that investors expect to earn from an investment without any risks. We’ll use a return of the 10-year Government Bond as a Risk-Free Rate.
- Market Risk Premium: the rate of return over the Risk-Free Rate required by investors. For calculating the discount rate, you use the market risk premium data from NYU Stern School of Business.
- Total Business Debt: total liabilities of the company
- Total Business Cash: the total cash and cash equivalents of the company.
Step 2: Calculate the Discount Rate (WACC)
This is the most crucial part of our of discounted cash flow analysis. If this point is not done correctly it will throw off the future calculations and lead to an incorrect intrinsic value, which will lead to a possible purchase of an overvalued company. Leading to losses in your investments.
The key to this calculation is not assuming the same discount rate for every stock. You need to calculate the rate for each individual company or you could end up in a world of hurt.
Continue reading “6 Easy Steps to Discounted Cash Flows for Beginners”