The discounted cash flow (DCF) method is one of the more popular choices for finance professionals. I often use DCFs as a rough, back of the envelope calculation to see if the business is trading at a reasonable price. The thing I like the most about DCFs is that they factor in the growth of the business. Valuation ratios, such as price-earnings, are just a snapshot of the business at that point in time. In this post, I don’t want to get into the math, or how to make super accurate DCF models. However, I will provide an introduction to discounted cash flow analysis, by describing the four inputs to the DCF calculation.
In simple terms, a DCF approximates the value of a company based on the stream of cash flows it generates into the future, a growth rate of these cash flows, and then factors in the investors time value of money (ie their desired rate of return).
Cash Flow
The first DCF input is the amount of cash flow the businesses currently generates. Cash flows can be measured in several ways, such as net income, earnings per share, free cash flow, among others. I typically use free cash flow (FCF) because I believe it is a better measure of the earnings an owner would receive from the business than net income.
Using the latest FCF number makes sense if the business is stable and predictable. However all businesses are going to have varying cash flows year to year. Some companies are cyclical, so you don’t want to use the peak earnings for that economic cycle. Other companies produce very random earnings, complicating things as well. Instead of using the current free cash flow, in most cases it makes more sense to average the past few years value. I usually average the last three years of FCF as the input to the DCF. For companies that seem cyclical, or have an unusually high FCF figure for the current year, I will handicap it a bit to a more conservative value.
Growth
A reasonable business is going to produce a certain amount of cash flows into perpetuity. Ideally, these cash flows are growing as well. The growth rate assigned to the businesses cash flows is the next input to the DCF model. A large, stable business may grow at the rate of inflation, so about 2-3% per year. Many businesses can grow above the rate of inflation, and certain companies (like tech stocks) can grow their business at high rates. High growth rates can greatly increase the value of a company produced by a DCF.
A Note On High Growth Rates
High growth rates are why some stocks can appear expensive on a price-earnings basis, but they may be a reasonable price when you factor in high future growth. However, many times everyone is saying that a stock is The Next Big Thing, that revenue will grow a ton, and the stock price will massively increase. These stocks are too expensive even though they may have high growth rates. DCFs anchor the growth of the business to its fundamentals, allowing the investor to make sure the growth story isn’t getting ahead of a reasonable valuation.
The problem with plugging a growth rate into the DCF model is that it is an estimate since we cannot predict the future. Oftentimes narratives about a stocks high growth prospects is pumped by the financial media. It is easy for an investor to get caught up in the hype and plug in an unrealistically high growth rate when performing DCF analysis.
The other problem is that companies cannot sustain high growth rates forever. There are eventually diminishing returns, where the company’s growth will slow as it gets larger. DCFs typically use a 10 year forecasted growth value. An investor has to be careful that even though the company has grown at 10% the last few years, it will still be growing at that rate ten years from now.
Calculating Growth
There are many ways to estimate a businesses growth rate, such as historical revenue growth, net income growth, FCF growth, or the company’s return on equity. I typically use a 5 year average of revenue growth. This probably isn’t the best way to estimate growth, but this metric is easily found on the website I use to research stocks. Like with the FCF, I often handicap the revenue growth rate by lowering it a couple of percentage points just to produce a more conservative valuation.
Terminal Growth Rate
The growth rate discussed in the previous section estimates the growth in the next 10 years. Since the DCF assumes the business is going to produce cash flows in perpetuity, we need to use a growth rate from year 11 to forever. Since diminishing returns will take into effect eventually, we can assume that after a long enough time the company will just grow at the rate of inflation. For my DCF calculations, I use a terminal growth rate of 2%.
Discount Rate
The discount rate is the last input used for the discounted cash flow model. Discount rate is the hurdle rate, or the investors desired rate of return on the investment. Finance professionals and academics typically calculate the discount rate by using the businesses Weighted Average Cost of Capital (WACC). In simpler terms, calculating WACC, produces a discount rate that reflects what the market thinks is reasonable for the business. I am critical of the WACC method, but that is a discussion for a different day.
The other method of determining a discount rate is to just use a personal desired rate of return. When I perform DCF analysis, I almost always use a 10% discount rate. I figure this value is not too low, or too high, but should still beat the market.
DCF valuations are highly sensitive to the discount rate you use. A lower discount rate will increase the value of the company. This is because you are willing to pay more for this stream of cash flows and accept a lower return. This can create a tricky dynamic because I am a young, hungry investor who wants to beat the market. In this case, I want to use a 10% discount rate. However, I am competing with some institutional money manager that is ok buying stocks that return 7% a year. Many stocks seem reasonably priced at a 7% discount rate, but would have to fall a large amount to be cheap based on a 10% discount rate.
Conclusion
This wraps up part 1 of the introduction to discounted cash flow analysis. I described the four DCF inputs (cash flow, short term growth, terminal growth, and discount rate), and how to calculate them. Keep in mind that DCF inputs are all estimates. This can lead investors to creating overly optimistic valuations. However, I believe the main benefits to using DCFs is that they can help an investor really think about the business, since it considers the current earnings power, the growth of the business, and the time value of money. By introducing DCFs, I can help support one of the themes of this blog: don’t buy hyped up growth stocks.
For more value investing fundamentals check out:
What is Value Investing Anyway?
The Many Flavors of Value Investing