 Discounted Cash Flow Model to value a stock? "Pin It")
A Discounted Cash Flow Model is a method used to determine the value of a business by projecting its future cash flow and discounting that value back to the present value. This technique assists investors in making informed decisions about whether the future cash flow is worth investing in at the current market price.
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The Discounted Cash Flow Model explained.
The Discounted Cash Flow (DCF) model is a commonly used valuation method that helps determine the worth of an investment by estimating the future cash flows it is expected to generate. To determine the present value of these cash flows, they are extrapolated over a specific time period and discounted back to today’s prices using an appropriate discount rate.
The value of a business is determined by the cash it can generate for its equity owners throughout its lifetime. This is why cash flow is preferred over other financial metrics. The Discounted Cash Flow model valuation is based on the idea that the value of a business or a project is determined by its ability to generate cash flow for those who invest in it. Otherwise, why would anyone invest?
The value of a business is the cash itโs going to produce in the future.
Warren Buffett
The DCF model is not only used by investors to determine the value of a business but also by management when making investment decisions. If management is considering investing in a project or an asset, they would want to ensure that the return on capital is higher than the cost to develop it. After all, why invest otherwise?
Do we have to use cash flow?
Cash flow or FCFF (Free Cash Flow to Firm) represents economic value more so than other accounting metrics like EBITDA. As an investor I want cash as that is what I value more so than accounting profits on paper. Cash flow is a lot harder to “fiddle with”.
Once more, “The value of a stock is determined by the present value of its future cash flows. No more and no less.” This means that a business generates value by using the capital it receives from equity or bondholders to invest and generate returns. Free cash flow is the amount left after covering the operational expenses of the business.
This is the true value of the business because it represents the amount of money that the owners can use without affecting the sustainability of the business. Free cash flow can be used to reinvest in new opportunities, distribute among shareholders through dividends or buybacks, or pay off any outstanding debt.
Why do we discount the future cash flow?
The present value refers to the current value of a future cash flow, discounted back to today’s prices. This discounting is necessary because the money we may receive in the future is worth less than it is today. Although we cannot invest in future cash flow, we can invest the capital we have today to generate a return. It is essential to comprehend the time value of money and how Inflation can erode a dollar’s value over time. This principle of โtime value of moneyโ is the foundation of Discounted Cash Flow model analysis.
Investing in a business is different from depositing money in a bank and earning interest, as with the latter, we know the exact amount we will earn at the end of the term. However, when investing in a company, we anticipate future cash flow, and there is always uncertainty around that return.
There are two other important factors to consider: opportunity cost and risk. For instance, can we invest our money in alternative investments today and generate a return? We must also consider the risk factor as the money we receive today is worth more than the money we may or may not receive in the future. We need to factor in that the future is uncertain, and we may lose our capital.
Why is the Discounted Cash Flow Model important?
Using a Discounted Cash Flow (DCF) model is a crucial aspect of valuation. It enables investors to examine a business by studying its financials, model, and potential future outcomes. It requires a thorough investigation and analysis, which can help make more informed decisions.
The Discounted Cash Flow model is based on the concept of “Intrinsic Value,” which is the true worth of an enterprise, rather than the market value placed on a stock that can fluctuate with market sentiment. The DCF model, despite its significant flaws, is still an effective way to assess a business.
The discounted cash flow model of valuation is the most helpful tool for separating intrinsic and extrinsic values.
Naved Abdali
However, there is one caveat when using the Discounted Cash Flow model: am I capable of modelling this business with confidence to predict its perceived value? If I am uncertain, I skip the company. It’s that simple. Some investors and analysts may be better equipped to model a business out, but if you lack the confidence to evaluate the business and create a model, you shouldn’t invest or try to extrapolate something you have no idea about.
What is the Formula for the DCF Model?
All though the formula looks a little complex, it is quite simple to understand once we go through each of the terms. Once we have understood the terms, we will walk through the stages of the DCF and then run an example to illustrate how it comes together.
- DCF = Discounted Cash Flow
- CF = Cash flow Period (Number is the Year).
- r = Discount Rate / WACC / Opportunity Cost
- n = Cash flow for final years (Terminal Value)
Cash Flow
โCFโ is expected cash flow for the given year. The forecasted cash flow is the amount of money expected to come in and out the business during a specific period of time.
For the Cash Flow component we are taking the companies Free Cash Flow. As explained above this is the key metric we are after as investors. We are going to use the TTM (Trailing Twelve Months) Free Cash Flow from the business. Looking at the cash flow statement, we can determine what this is by looking at all the cash from operations and then deducting Capital Expenditures (cash outflows to support operations and maintain its capital assets).
Discount Rate
๐ Prior Reading: Discount Rate | Weighted Average Cost of Capital | Cost of Equity
The discount rate is a crucial component of the DCF Model, and getting it wrong can result in an inaccurate valuation. The discount rate is highly debatable and can vary depending on who is valuing the business. As we learned in forecasting and modelling, it is a game that depends on various assumptions. Therefore, it is best to look at the discount rate on a case-by-case investment opportunity and outline your return expectations.
There are a few ways to use the discount rate. The first is to understand the impact of higher or lower discount rates.
Higher Risk = Higher Discount Rate
This increases your Margin of Safety. Higher Risk Investments should use higher rates, which will result in lower valuations. This leaves a lot of room for error. The higher discount rate means the stock price will be lower on the stock valuation to provide you with a margin of safety.
Lower Risk = Lower Discount Rate
A lower discount rate results in a higher valuation. The higher valuation on the stock price is because you don’t need as much of a margin of safety built-in, and you’re willing to pay fair prices for a good company.
You can then decide on the appropriate rate. Below are some common rates used by investors.
Weighted Average Cost of Capital (WACC): This is a commonly used discount rate because it combines both sources of capital for a business, equity, and debt. The company uses the WACC as its own opportunity cost when evaluating investment opportunities.
Risk-Free Rate: You can use the risk-free rate plus or minus a few points to keep in line with evolving interest rates or bond rates. This rate is used because it is a guaranteed rate of return for an investor. So why risk capital for anything less than the Risk-Free Rate?
Opportunity Cost: This is the main rate I believe investors should use. If you have other opportunities to place your capital to work, whether it is in the stock market or outside, such as real estate or private equity, then that should be the discount rate. If I can get a guaranteed rate of return of 8% a year on a property, then I would want to get more than this to place it in a stock. This should be what you can earn with a high degree of certainty.
Your Expected Returns: If you want to make 10% annually by holding an investment in a stock, then that should be the discount rate. This builds in a 10% margin of safety, and if all things align and our DCF is correct, and we buy based on the valuation, theoretically, we should achieve a 10% return on our investment.
Discount Rate Chart
| Riskiness Level | Discount Rate |
|---|---|
| Very Low Risk = Consistent | Mature | Stable | 4-7% |
| Low Risk = Predictable + Still Growing | 7-9% |
| Average Risk = Normal level of risk | Go to rate | 9-11% |
| Higher Risk = Inconsistent | Not far from FCF | 11-13% |
| Extreme Risk = Start Ups | Unpredictable | 13-16% |
๐ข The riskier the investment the higher the required rate of return (higher the cost of capital) which means a higher discount rate. The further out the cash flow is, the higher the risk it is. So, we need to discount this even further. This creates a margin of safety.
Periods of Time
Most Discounted Cash Flow models are modelled out across a 5-10 year span. I try to work on 10-years for more mature businesses and 5-years for smaller companies. The reason why is 5-years to a small business is a very long time frame. A lot can happen if a business delivers, crosses the chasm, achieves scale, or does not. There will be a huge difference in an additional 5 years. For more mature companies with consistent free cash flow and sustainable earnings power, a 10 year time horizon is more likely.
Terminal Value
๐ Prior Reading: Terminal Value
Determining the terminal growth rate is crucial in the valuation process and can be done using either the perpetuity method or the multiples method. The terminal growth rate constitutes nearly half of the valuation, so it is essential to be cautious as even a small variation can significantly impact the valuation. The terminal value represents the growth in free cash flow for an indefinite period, and the time period should be chosen adequately.
For instance, if the forecasted period is ten years, one should not run a model for 25 years after the forecasted period. Instead, the terminal value should be determined beyond the last forecasted year forever. Companies cannot grow at above-average growth rates for ever.
The perpetuity model uses a growth rate usually tied to inflation. This is because a sound investment should at least compound in line with or better than inflation. It is recommended to be conservative and use a range of 2-4% depending on the company.
The multiples method is also prevalent. It uses the last year’s projected metrics, such as earnings, sales, or cash flow, and applies a multiple on the business in line with other companies.
Suppose the forecasted period is ten years, and we plan to sell the company after year ten. In that case, we can take the last year’s EBITDA and apply the most common ratio EV/EBITDA. If we have $10 million EBITDA in year ten and compare this business to the market and comparable companies that trade at, say, 9x, we can multiply $10m by 9 to get $90 million. We then take this terminal value and discount it back to get the net present value.
Enterprise Value
๐ Prior Reading: Enterprise Value
The last step in determining the value of a company is to calculate its Enterprise Value, which is the sum of the market capitalisation including the impact of debt and cash. By considering the debt and cash on the final sum of the valuation, it provides a better picture of the Equity Value of the Company, which is owned by shareholders. This helps in determining the Intrinsic Value estimation, which can be divided by the total shares on issue to arrive at a per-share valuation price.
The Enterprise Value formula in the DCF (Discounted Cash Flow) model is the sum of the Net Present Value (NPV) of the 10+ year Free Cash Flow (FCF) and the NPV of the Terminal Value. We then subtract any cash on the books and add in long-term and short-term debt.
The Enterprise Value provides a clear picture of what it would take to purchase the entire company and take it off the market. It is also used for the Multiple Valuation method, making it helpful to have the EV component ready.
Where to use the DCF Model?
The Discounted Cash Flow (DCF) model is most effective for companies that have already passed the operating leverage phase and are achieving capital returns. It is not based on the size of the company, but rather its business model. I have invested in many small-cap companies that had strong free cash flow, no debt, and were consistent in their growth.
It is important to consider the business life cycle when using the DCF model. A company that is scaling and not yet profitable is earning negative free cash flow because it is using all of its resources and costs of capital to invest back into the business to help it grow. It can be challenging to model a company in negative free cash flow and predict when it will achieve break-even or positive free cash flow.
Other valuation methods can be used for different business cycles. The DCF model is best suited for companies that are consistent, generating positive outcomes and are not as volatile. While it is possible to forecast and model out the financial statements, there is a higher degree of risk in getting the inputs wrong based on a variety of assumptions.
Although all projections are estimations, a consistent company with positive cash flow and a track record has a better chance of being projected accurately than a company that lacks stability year-on-year.
What are the stages to building a DCF model?
When building a detailed Discounted Cash Flow Model, it’s important to consider if you’ll be conducting highly detailed forecasting and Financial Modelling using the 3 Statement Financial Model. This involves reengineering the income statement, balance sheet, and cash flow statement to build a forecasted look at all the line items of a business.
The in-depth modelling work of rebuilding the statements will depend heavily on your understanding of the inputs and working capital requirements of the business. In the steps below, we’ll be working with known variables such as the TTM cash flow and studying past data to determine the appropriate growth rates.
| The Stages of Building a DCF Model |
|---|
| โฌ๏ธ Step 1 Look at the last five years of the companyโs cash flow statement. Take the average Growth Rate. |
| โฌ๏ธ Step 2 Look at the Free Cash Flow growth rate from trusted sources, analysis and platforms like Tikr. |
| โฌ๏ธ Step 3 Find the trailing twelve-month (TTM) free cash flow. This will be your starting year 0 input. |
| โฌ๏ธ Step 4 Estimate the FCF growth rate based on the forecasted information and considering the average. |
| โฌ๏ธ Step 5 Forecast the Free Cash Flow for the next 10 years based on the expected Growth Rate. |
| โฌ๏ธ Step 6 Determine appropriate discount rate then multiply FCF by the discount factor to get Present Value. |
| โฌ๏ธ Step 7 Determine the Terminal Value using the perpetuity method or Multiple Exit method. |
| โฌ๏ธ Step 8 Discount the Terminal Value sum to the Net Present Value. |
| โฌ๏ธ Step 9 Add the 10-year forecasted FCF period to the Terminal Value to determine the Enterprise Value. |
| โฌ๏ธ Step 10 Determine the Enterprise value (Equity Value) by adding cash and removing any debt. |
| โฌ๏ธ Step 11 Take the Enterprise Value (Equity Value) and divide it by the shares outstanding. |
| โฌ๏ธ Step 12 The outcome is a Price Per share in today’s value to compare to the current market price. |
An example using the DCF model.
Let us work our way through a full example of a Discounted Cash Flow model on a business we want to invest in. Using the below assumptions, we can map out what an intrinsic value would be.
| Assumptions | |
|---|---|
| Current Stock Price: | $12.76 |
| Outstanding Shares: | 41,900,000 |
| TTM FCF: | $21,003,000 |
| 10-Year FCF Growth % | 10% |
| Perpetuity Growth %: | 3% |
| Discount Rate: | 9% |
| Cash Holdings: | $7,760,000 |
| Total Debt: | $8,200,000 |
Forecast Free Cash Flow (FCF) over the next 10 years
| Yr1 | Yr2 | Yr3 | Yr4 | Yr5 | Yr6 | Yr7 | Yr8 | Yr9 | Yr10 | |
|---|---|---|---|---|---|---|---|---|---|---|
| Free Cash Flow | $23.10m | $25.41m | $27.95m | $30.75m | $33.82m | $37.20m | $40.92m | $45.02m | $49.52m | $54.47m |
Discount Free Cash Flow (FCF) by our Discount Rate to get Present Value
| Yr1 | Yr2 | Yr3 | Yr4 | Yr5 | Yr6 | Yr7 | Yr8 | Yr9 | Yr10 | |
|---|---|---|---|---|---|---|---|---|---|---|
| FCF | $23.10m | $25.41m | $27.95m | $30.75m | $33.82m | $37.20m | $40.92m | $45.02m | $49.52m | $54.47m |
| Discount Rate รท | 1.091 | 1.092 | 1.093 | 1.094 | 1.095 | 1.096 | 1.097 | 1.098 | 1.099 | 1.0910 |
| Present Value | $21.19m | $21.39m | $21.58m | $21.78m | $21.98m | $22.18m | $22.38m | $22.59m | $22.80m | $23.01m |
Determine the Terminal Value using our Perpetuity Growth Rate
To work this out we need to take the Year 10 Projected Free Cash Flow which is $54.47m. We use the Terminal Value formula which is:
(Year 10 FCF X (1 + g)) รท (r โ g)
(g = Perpetuity Growth Rate and r = Discount Rate)
So the formula will be ($54.47 x (1+1.03)) รท (0.09 – 0.03) = $935,177,734.6 Terminal Value
Then Discount this to the Present Value.
To discount this we use this formula TV รท (1+r)^10
So it will be $935,177,734.6 รท (1 + 1.09)10 = $395,029,181.5 This is our Net Present Value of the Terminal value.
Work out the Enterprise Value and determine the Equity Value.
To do this we first add the sum of the Net Present Value (NPV) of the 10-year forecasted FCF to the NPV of the Terminal Value. Then we make adjustments for cash and debt.
| Input | $ |
|---|---|
| Sum NPV FCF | $220,924,949 |
| NPV Terminal Value | $395,029,181 |
| Cash on Hand (+) | $7,760,000 |
| Total Debt (-) | $8,200,000 |
| Equity Value | $615,514,130.7 |
Then compare Intrinsic Value to the Current Price.
Once we have the Equity Value we can then determine the Share Price valuation. To do this simply divide the Equity Value (Market Cap) by the Shares outstanding.
$615,514,130.7 รท 41,900,000
Intrinsic Value Per Share = $14.69
Now that we have our estimation of Intrinsic Value based on our model we can compare this to the current share price to see if it is overvalued or undervalued.
Valuation = $14.69
Current Share Price = $12.76
Over/Undervalued = -$1.93 โฌ ๏ธIf it is positive it is Overvalued if it is Negative it is Undervalued
Upside/Downside = -15.13% โฌ ๏ธIf it is positive it is Overvalued if it is Negative it is Undervalued
Margin of Safety = 13.14% โฌ ๏ธIf it is Negative it means there is NO margin of safety built into the price.
The last part is running our Sensitivity Analysis.
The sensitivity analysis uses the information and inputs however looks at changes in the Discount Rate, Terminal Growth rate and the FCF Growth rate. As an example I have run 3 separate sensitivity analysis with all random changes in the rates. You can see the variance in the final outcome of the per share price.
| Sensitivity 1 | Sensitivity 2 | Sensitivity 3 | |
|---|---|---|---|
| Discount Rate % | 9.00% | 7.00% | 15.00% |
| Terminal Growth (%) | 3.00% | 2.00% | 4.00% |
| FCF Growth (%) | 10.00% | 8.00% | 4.00% |
| Enterprise Value | |||
| Total NPV FCF | $220,924,949.19 | $221,134,356.81 | $125,916,899.48 |
| Total Terminal Value | $395,029,181.46 | $470,231,022.95 | $72,656,918.70 |
| Cash on Hand (+) | $7,760,000.00 | $7,760,000.00 | $7,760,000.00 |
| Total Debt (-) | $8,200,000.00 | $8,200,000.00 | $8,200,000.00 |
| Equity Value | $615,514,130.65 | $690,925,379.76 | $198,133,818.18 |
| Valuation Per Share | $14.69 | $16.49 | $4.73 |
| Current Share Price | $12.76 | $12.76 | $12.76 |
| Over/Under Value | -$1.93 | -$3.73 | $8.03 |
| Upside/Downside | -15.13% | -29.23% | 62.94% |
| Margin of Safety | 13.14% | 22.62% | -169.84% |
We can see how the Sensitivity Test 3 with the discount rate and Growth rate how much it impacts the final share price showing an OVERVALUATION of 169.84%.
This can help us to value a business based on a range of outcomes. It is also helpful when looking back on a holding and making adjustments to new information as it comes along without having to redo the model every time.
This is a screenshot of my Discounted Cash Flow model (Based on this example) I have made to show you how it looks.
โฌ๏ธ Download a copy of my DCF Model template below.
The Cons of Using a Discounted Cash Flow Model.
The Discounted Cash Flow Model is a great way to value a business, but there are a few things to keep in mind. Firstly, projections become less predictable the further out in the future they go. While you may be able to accurately predict 1-3 years of stable free cash flow, projections beyond 5 years become much more uncertain.
Secondly, the model is quite sensitive to miscalculations, especially in regard to the discount rate and perpetual growth rate. Small errors or unrealistic growth projections can lead to significantly different valuations. It’s important to look back at the sensitivity analysis to see the variance.
We’re all just guessing, but some of us have fancier math.
Josh Brown
It’s also worth noting that the DCF model is based on assumptions. Investors can model unrealistic expectations and forecasts, which may lead to financial decisions based on an inaccurate outcome. As such, it’s important to use the Discounted Cash Flow model in combination with other valuation tools to get a better picture of the true value.
All valuation work is based on trying to forecast an unknowable future. It’s best to keep this in mind to not get fanatical about the models and obsess over it. It can be a very time intensive process running models.
If you’re comfortable projecting the free cash flow and have the right discount rate, the intrinsic value can provide a good guide to compare the current share price. However, if the valuation doesn’t seem reasonable, it’s important to run a few sensitivity tests and consider the likelihood of each outcome.
In Summary…
The Discounted Cash Flow Model is a financial forecasting tool that requires accurate estimation of the free cash flow growth rate, perpetual growth rate and discount rate. It’s important to consider the possible changes a business may undergo over time, especially if it currently has a high growth rate that may not be sustainable in the long run. To achieve accurate results, it’s essential to be conservative in predicting the growth rate for both the 10-year forecast period and the terminal value.
Using a Margin of Safety is always recommended in valuation, especially the Discounted Cash Flow Model. Although it’s closely related to Value Investing, it is more than a philosophy; it helps protect against incorrect assumptions. By having a margin of safety, it minimizes the risk of being too optimistic and buying overvalued stocks. If the margin of safety is only 5%, it leaves very little room for error if your valuation is off.
Look for more value in terms of discounted future cash-flow than you are paying for. Move only when you have an advantage.
Charlie Munger
If you’re not confident in modelling a company’s free cash flow, it’s best to move on to something else. Donโt even try to value the business. Sometimes, a DCF can become too complicated, and it’s better to leave it than to make incorrect assumptions. If you can’t model a business, it means you donโt know the business model well enough to put it into a spreadsheet, make projections and make financial decisions based on them. It’s better to leave it and move on to something you’re more confident with.
Discounted Cash Flow (DCF) Model Template
You can download and use a copy of my Discounted Cash Flow Model (DCF) below. It is not a very detailed one, however, gives me the information I need. It includes 3 Sensitivity checks as well
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