How to Value a Stock with Reverse DCF

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What the reverse DCF attempts to do in order to improve from the reputation of its twin, is to eliminate the need to forecast. Instead of starting with a given year’s FCF, and then projecting towards an unknown, the purpose of the reverse discounted cash flow is to calculate what growth rate the market is applying to the current stock price.

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Jae Jun

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How to value stocks series

For other posts in the series, follow the links below.

What is reverse DCF and its advantages over DCF valuation

Disadvantages of Discounted Cash Flow Valuation

I am a fan of the discounted cash flow valuation method. It isn’t perfect, but it also isn’t as horrible as a lot of people make it out to be. With everything, there is a strength and weakness. As long as you are aware of each, a DCF model is a valuable tool to have in your belt.

But first, let’s quickly go over the main weaknesses of DCF.

1. Projecting Future Cash Flow

All evidence points out that humans cannot predict. This is no different when it comes to projecting the future cash flow of the business. There is too much uncertainty when trying to forecast and you are also basing the future values based on past results.

With such forecasting, a small error can result in a drastic change in the DCF valuation.

2. Calculating a Proper Discount Rate

Unless you have a good understanding of what a discount rate is, this value can lead to inaccurate assumptions. A big problem is that you may end up playing around with the discount rate to match the intrinsic value you are seeking.

3. Predicting Growth Rates

The main problem with determining a feasible growth rate is that a DCF will simulate the growth rate to be on-going. Unless you apply multiple stage DCF valuations, a single growth rate is usually used to project the growth for the next 10 years.

In my own stock valuation spreadsheets, I use a decay to reduce the growth rate every certain number of years. It’s not a 2 stage or 3 stage DCF model, but similar and simpler.

Reverse DCF Overview

What the reverse DCF attempts to do in order to improve from the reputation of its twin, is to eliminate the need to forecast.

Instead of starting with a given year’s FCF, and then projecting towards an unknown, the purpose of the reverse discounted cash flow is to calculate what growth rate the market is applying to the current stock price.

In other words, by working backwards, you can see whether the implied growth rate by the market is higher or lower than what the company is capable of.

Let’s see how it is actually done.

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Reverse DCF Valuation of Microsoft (MSFT)

Using the DCF model from the premium stock valuation spreadsheets, set the discount rate to 9%.

My rule of thumb for large caps is to calculate the discount rate as

discount rate = risk free rate + risk premium

with the current risk free rate being approx 3.5%

large cap discount rate = 3.5% + 5% = 8.5%

and you can round up the 8.5% to 9%.

Now that you have the discount rate set to 9%, play around with the growth rate until you get a value that matches the current price.

On my spreadsheet, the growth rate has to be set to -2.6% for the reverse DCF valuation to match the current stock price.

(The -2.6% value should be used as a ballpark figure and not the gospel as my spreadsheets contains more customization than a regular straight line DCF.)

Click to enlarge image.

Reverse DCF MSFT

Here, you see that the market is currently pricing MSFT to have negative growth. Whether this is true or not is up to you, but it is definitely hard to imagine a free cash flow machine like MSFT shrinking year over year.

However, recent news of the drop in Windows OS sales and the purchase of Skype could very well prove to be an indication of a slowly declining business.

Reverse DCF Valuation of Cisco (CSCO)

With all the negative press and sentiment on CSCO, it couldn’t be more hated on Wall Street than now.

Sticking with the same discount rate of 9% as MSFT, the implied growth for CSCO is at a jaw dropping -9.6%

Again, this is a ball park figure, give +/- 2% to the final value.

The more important question now, is whether the business of CSCO really is going to continue slide at such speed.

Initial thoughts lead me to believe the answer is no.

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Reverse DCF as a Point of Reference

So that’s how easy a reverse DCF can be applied. Just match the intrinsic value to the current price and ask yourself whether the growth rate makes any sense.

It simplifies the DCF thought process and output from “what is the future growth rate?”, to “is the expected growth rate realistic?”.

Always remember that the growth rate you end up with is a frame of reference that will help you with your research, NOT the reference point or the deciding factor in concluding whether a stock is cheap or not.

• ASTA

Hello Jae,

I am falling in love with your spreadsheet more day by day. Its
a nice starting point for stock research.
And a perfect tool to eliminate stocks fast.

Cheers,

ASTA

• http://www.oldschoolvalue.com Jae Jun

Hi Asta,

Thank you and I’m very glad that you like it.

• David

Hi Jae,

Thanks for writing the blog. Very helpful. One tip regarding it though: can you please put the title of the blog post inside the html title tags as well? I sometimes want to save your posts on Delicious and it only grabs “How to invest”. It’ll also help with the search engines I guess.

• http://www.oldschoolvalue.com Jae Jun

Thanks for pointing that out. I’m working on fixing it.

• bp

should you be backing out net debt instead of just cash?

• Mark

Jae,

What about adjusting the terminal growth rate and the discount rate? Currently it defaults to 3%.

• http://www.oldschoolvalue.com Jae Jun

A terminal growth rate of 3% is fairly conservative so it shouldn’t matter much. Discount rate remains consistent.

• http://www.wealthsavant.com Wealth Savant

Great Analysis! I prefer DCF as well when looking for deep discounts!

• Bart

Hi Jae,

I see that you are discounting ‘owner earnings’ in your valuation of MSFT and CSCO. Are these equivalent to FCFE? If so, this would be consistent with using a cost of equity or required return as the discount factor. In the event that you include Interest income in FCFE, Cash should not be added to the PV in my opinion.

Best regards.
Bart

• John F.

Hi Jae, does this model also work for companies in the financial sector – particularly banks?

• http://www.oldschoolvalue.com Jae Jun

Hi John,

It doesn’t for banks straight out of the box because bank financials are different. Instead, you need to adjust the numbers. As long as you at least know what the TTM FCF or the expected FCF, it’s pretty straightforward.

• http://www.oldschoolvalue.com Jae Jun

Hi Bart,

It looks similar but FCFE is not owner earnings and cost of capital requires a lot of input to calculate which many people won’t be able to do. So it’s best to stick with something simple and put in a discount rate manually.