The Reverse DCF Model is an excellent tool for valuing a stock based on the market’s pricing rather than your own forecast. This model uses the Inversion concept which is a modified version of the Discounted Cash Flow model. By beginning with the current stock price and adjusting the expected growth of the business, we can determine the amount of growth that is factored into the share price.

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What is a Reverse DCF Model?

The Reverse DCF model is my preferred method of valuation. I believe it is a better tool than trying to forecast intrinsic value and run projections of an uncertain future. I find it more practical to see what market expectations have been built into the price. By backing out the growth that the market has placed on a stock, I can then determine whether it is overvalued or undervalued by those standards.

It eliminates the need to forecast. By using a reverse-engineered Discounted Cash Flow Model, I can look at the implied assumptions of investors and see how that correlates to the business fundamentals being able to achieve that expectation.

Using a DCF Model is still a good practice to value a business, and is not as bad as many claim it to be. However, by reverse-engineering the current price we can determine already without the effort of modelling what price is built in. The formula is a “touchstone of absurdity”.

While the outcome will still be determined based on what I believe the business can do, it is still a very helpful way to evaluate a business.

By backing out the price that has been built-in, you can evaluate whether you believe it is a reasonable growth rate or not. If it is possible and quite conservative, you know it may be undervalued. If the growth is absurd and very aggressive, it may be overvalued and expensive.

I believe it is a better way to look at value by considering market sentiment and expectations. Even a fantastic company with the greatest growth prospects that is purchased too high will make for a poor investment.

Valuation based on what the market has built-in.

As a recent example, I was looking at a small-cap company generating free cash flow, however, trading at a ridiculous price even by my standards.

Investors were placing multiples on this business as though it was the next AI SaaS business, but it was a financial services business offering professional services. The business model made it quite challenging to forecast with any certainty past year 5. By using traditional valuation models the intrinsic value was miles away from the current share price. So I inverted the analysis to see why the current share price was so high compared to my analysis.

By backing out the price and inverting the assumptions, the market was placing 150% FCF growth per year! It does not take a genius to know that this is exuberant Mr Market at its finest. Over a year, the price came crashing down when the euphoria died out.

Sometimes, it’s better to approach stock valuation by working backwards. Instead of trying to predict where the stock price will be in the future, start by assessing where it stands currently.

Next, figure out what the company needs to achieve in order to reach that price point. Finally, evaluate whether this outcome is achievable or not. I personally prefer to look at things from a different angle, this helps me to think more creatively.

Even if an idea seems overvalued, don’t dismiss it outright. Instead, ask yourself, “What does the company need to do to grow into this price?”

Why is a Reverse DCF Model a better valuation tool?

A DCF model is used to predict future revenues, earnings, and free cash flow by considering certain information that we have. It is a forward-looking approach that can be biased because accurately estimating future cash flows is not always possible. To match our intrinsic valuation or create a margin of safety, we sometimes adjust the growth rates and discount rates to align with our valuation. This approach can cause investors to anchor to certain prices. Stock Valuation is riddled with behavioural traits and biases.

Invert, always Invert: Turn a situation upside down, look at it backward.

Charlie Munger

The reverse DCF method helps eliminate this bias by backing out the price and removing the need to forecast. However, investors can still be biased if they like a stock and want to invest in it. They may ignore the output and believe unrealistic growth expectations are achievable. There is no valuation method to protect investors who are attached to an idea.

Once we have worked backwards and found the growth rate, we need to assess whether the company can achieve it. We must determine the free cash flow the company needs to grow and produce to justify the current share price.

Unlike the DCF model, which tries to predict the future, the reverse DCF method looks purely at what price investors are willing to pay for future cash flows.

How to use the Reverse DCF Model to value a stock?

The process of conducting a Reverse DCF Model is quite simple. We first need to use certain inputs from the Discounted Cash Flow Model, such as the Discount Rate and the Perpetuity Growth rate for the Terminal Value. Then, we input the known variables and follow the stages of the Reverse DCF model.

Once all the data is added, we manipulate the FCF Growth rate until the Implied Intrinsic Value matches the current share price. After it matches, the output shows the growth rate that the market has built into the price.

📖 Prior Reading:

• Discounted Cash Flow Model
• Discount Rate
• Terminal Value and Perpetuity Growth Rate
• Enterprise Value

The Stages of Building a 🔀 Reverse DCF Model
⬇️ Step 1 Get the current share price, this is what we are comparing the model to.
⬇️ Step 2 Find the TTM Free Cash Flow. The use of the Reverse DCF is best for companies with +FCF.
⬇️ Step 3 Find the Shares outstanding.
⬇️ Step 4 Determine the Perpetuity Growth rate which should be between 2-4% for the Terminal Value.
⬇️ Step 5 Add in the Discount Rate or the return you expect to receive.
⬇️ Step 6 Add in the cash and also debt to determine the Enterprise Value of the business.
⬇️ Step 7 Then we play around with the Free Cash Flow growth rate of the model.
⬇️ Step 8 We stop when the FCF Growth rate matches the Implied Share price with the current price.
⬇️ Step 9 Once this matches the Implied Growth Rate is the FCF Growth rate you used to match the prices.
⬇️ Step 10 Then we analyse the FCF growth rate built in and ask a range of questions.

An example using the Reverse DCF Model Method?

Let’s now run through an example of using the Reverse DCF Model to illustrate how the concept works. Using the below assumptions let us see what has been built into the share price by the market.

Once we have added all of the assumptions the final step is simple. We adjust the FCF Growth from years 1-10 until the Implied Share Price matches with the Current Share Price. This output gives you the Implied FCF Growth rate.

In this example, we have come up with the below numbers from my Reverse DCF Model.

The Implied FCF Growth rate is 29%

We can see how like the Discounted Cash Flow model we still get a forecasted FCF over 10 years in addition to the Enterprise Value. This is still useful to see how those projections are played out. It is helpful to play with the inputs and run a similar sensitivity test. If the numbers seem conservative you can add your assumed FCF growth rate which will show you the margin of safety to the current value.

I use my Reverse DCF Model the most.

⬇️ Download a copy of my Reverse DCF Model below.

What is the best way to analyse the results?

The final part of the analysis requires us to think deeply about valuation. Although it may be different from a more quantitative approach, it forces us to consider whether the market’s expectation of a company’s Free Cash Flow (FCF) growth rate is optimistic or pessimistic. We need to ask ourselves, “Does the market’s expectation of a 29% FCF growth rate annually seem unlikely or likely?” Answering this question will help us determine whether the company is overvalued or undervalued.

To make an accurate comparison, we need to look at the historical data of the company. If the implied FCF growth rate is above the company’s average historical rate, it suggests that investors are overly optimistic about the future of the company’s ability to generate FCF. Conversely, if the implied FCF growth rate is below the historical average, it indicates that investors are not valuing the future cash flow as highly.

To determine the company’s future prospects, we must understand the competitive landscape, industry, and market size. Just because a company is implying a high FCF growth rate does not mean it is not worth investing in. If a company can deliver on its FCF expansion, then the high growth rate is warranted.

Although the Reverse DCF model is a simpler and more effective way to value a business, investors still need to conduct research and due diligence to understand the industry, market size, and other competitors to paint a clearer picture of growth.

Questions to ask on the outcome?

If a company’s implied Free Cash Flow (FCF) growth rate is lower than what we expect, we need to understand why the market is not valuing it highly. Is there a decline in market share, changing business fundamentals, or a loss of margins and operating efficiency? Answering these questions can help us determine why the market is not valuing the company highly.

On the other hand, if the Free Cash Flow growth rate is high, we need to understand why investors are valuing it this way. Are revenues growing? Is the company becoming more efficient with working capital? Are the margins improving and increasing? Sometimes, the future outlook warrants a higher price.

I have invested in both outcomes. By making up your assumptions on growth backed with sound fundamental research, you can take guidance from market expectations without just following the herd.

The key is to use the market’s expectations and ask a range of questions like why have the majority valued future cash flows in this way? By reverse engineering expectations, it forces you to ask questions you may not have asked by merely running a forward-looking valuation model.

In Summary…

When I come across an investment idea, I use the Reverse DCF (Discounted Cash Flow) method to quickly assess its value. If the result aligns with my expectations, I begin the groundwork for the investment. But if the value is too high, I use a pre-checklist to determine the likelihood of success. I also use the Reverse DCF to keep track of current holdings and their value points.

This is my preferred valuation method, as it helps me save time while sifting through investment ideas. By inputting some numbers, I can quickly get a feel for where the market values the outlook of a business. I also try to identify what I might be missing and what others see that I don’t. I use this method to identify exit points as well.

If the result of the Reverse DCF is in line with my assumptions of the FCF (Free Cash Flow) growth, I proceed with the investment process. However, I cannot perform detailed forecasting and modelling for every idea that comes my way. Hence, I use my own Reverse DCF calculator, which is simple and takes only 10 minutes to assess an idea.

While some calculators include detailed earnings and working capital calculations, I believe that it takes away the point of the exercise. Recently, I came across a highly detailed Reverse DCF model, which was not much different from any other modelling technique.

However, the purpose of the exercise is to analyse the assumptions rather than get an accurate growth rate. Therefore, I use the Reverse DCF not as guidance to intrinsic value but rather to identify why certain assumptions were made and whether there is an opportunity worth investigating further.

Reverse DCF Model Template

You can also download a copy of my Reverse DCF Model below. I use this the most. It helps me to evaluate opportunities efficiently by looking at what growth has been priced in by the market.