In part 1 of this series, I introduced the discounted cash flow model and its four input variables. These variables were cash flow of the business, short term growth rate, terminal growth rate, and investors discount rate. In this post, I will show how to calculate a DCF by running the numbers on Emerson Electric (EMR). Emerson is an established business that is not rapidly growing, and is not overly cyclical. Using a DCF is more suitable for a business with these characteristics.
PV of Future Cash Flows
Performing DCF analysis consists of three parts. The first part is looking at the company’s financials to determine the values we should use to plug into the model. Next is the calculation of the present value of future cash flows from the business. This means we have a black box that produces a certain amount of cash flows far into the future. The DCF equation allows us to place a value on this stream of cash flows. The last step is to make some adjustments so that we get the value of the company on a per share basis.
Determining Cash Flow
The first step is to determine what cash flow value to use. In this example I am using EMRs free cash flow (FCF). The FCF for the last few years, plus the trailing-twelve-month figure is shown in the table. Typically I average the last few years of FCF to use as the input to the model. In this instance, let’s use $2.5B as our starting cash flow.
Choosing a Short Term Growth Rate
Next, we have to determine a reasonable growth rate. Emerson is a diversified industrial company that sells HVAC units, tools, and the InSinkErator brand. These products are going to produce a low sales growth rate. Probably increasing a few percent a year at the rate of inflation. EMR also has an industrial automation division that could have a bit higher sales growth going into the future. For this example, let’s assume EMR can grow their free cash flow at a rate of 3.5% a year.
The Terminal Growth Rate
As described in part one of this series, I discussed the difference between short term growth rate and terminal growth rate. Terminal growth rate assumes the business will decline to a steady state growth rate that is about the rate of inflation. In my DCF models, I typically use a terminal rate of 2%.
Specifying a Discount Rate
The last piece to the DCF model is the discount rate. As a refresher, the discount rate is the investors desired rate of return. This desired rate of return affects the future cash flows of the business. One dollar is worth more today than it does 10 years from now. Because of inflation and because we can invest that dollar. Mathematically, the discount rate has an interesting effect on the future cash flows. However, I’m trying to keep light on the math in this series so that can be a tale for another day. For my models, I use a discount rate of 10%. Don’t forget that a higher discount rate will mean the stock needs to trade cheaper. And a low discount rate means you could pay up for that stock (you’d be getting less of a return).
Performing the Calculation
Bringing it all together, we are now ready to do the DCF calculation. I use the calculator from Old School Value, which is a paid service, to do my DCF analysis. However, there are many online DCF calculators, or you can do it in Excel. Inputting the four variables described above, the DCF spits out a present value of EMRs future cash flows equating to $27B.
What this means is that we have a black box that is throwing out $2B in cash that is growing at a rate of 3.5% a year. If we paid $27B for this black box, we would expect a 10% return on investment. In order to arrive at a per share value of EMRs future cash flows, we need to do a few adjustments to this $27B.
Converting to Equity
The last step in showing how to calculate a DCF is to convert the DCF output into a value per share. The number that the DCF calculation produces is really the value of the entire enterprise. The enterprise is commonly made up of equity (the stockholders) and debt (bond holders). Since we are buying the stock, we need to adjust the $27B enterprise value of Emerson to reflect the equity holders’ share of the pie. To illustrate this, let’s say the enterprise was made up of 50% equity and 50% debt. It is not fair to say that the equity holders get 100% of the cash generated by the enterprise. You have to make debt interest payments, and pay off the bonds when they come due.
To arrive at the equity value, you take the enterprise value and subtract the value of the long term debt the company has. In some cases, it is applicable to also subtract capital lease. Emerson has $7B in debt, so we subtract that from the $27B. The next step is to add back the current amount of cash the company has. This means we can add $2.5B to our $20B. This resulting figure of $22.5B is the value of Emerson’s equity.
From here, we can obtain the value of EMR at a per share basis by dividing the $22.5B equity value by the amount of shares outstanding. Currently, Emerson has 600 million shares outstanding. This results in a per share value of $49.90 for Emerson’s stock.
DCF Example Summary
To summarize, if we could buy EMR stock at $49.90, and our DCF assumptions held true, we could expect a 10% average rate of return. Now that we have determined a back of the envelope value for EMR, we can check what it’s trading for in the market. When I entered my position in EMR, I paid $41 a share. Currently, Emerson is trading for about $70 a share, so you probably would expect a lower return if purchased at that price. Buying below the value calculated from the DCF provides some margin of safety in case our assumptions on Emerson’s cash flows or growth rates are wrong.
Conclusion
With this two part series on discounted cash flow analysis, I hope to provide a foundation for business valuation by showing how to calculate a DCF. Understanding that a stock is really a business that produces a stream of growing cash flows instead of a price that fluctuates is key to being a successful investor. Even though DCF valuations are not perfect, they do capture the growth of the business where a simple P/E ratio does not. Going forward, I want to occasionally highlight examples stocks are overhyped and trade at valuations that do not make sense, even if they can produce a high rate of growth.
For more value investing fundamentals check out:
What is Value Investing Anyway?
The Many Flavors of Value Investing