The purpose of the Discounted Cash Flow (DCF) valuation is to find the sum of the future cash flow of the business and discount it back to a present value. I use the F Wall Street method of valuing a business along with some tweaks here and there to suit my tastes in the free and best valuation spreadsheets you can find on this site.
The advantage of this method is that it requires the investor to think about the stock as a business and analyze its cash flow rather than earnings.
The first and foremost reason a business exists is to make money where money = cash, not earnings. Since cash is what a business needs in order to maintain and grow its operations, it’s only right to consider the possibility of its future cash growth rather than earnings growth.
The disadvantage is that DCF is not suitable for start ups, growth companies or capital intensive companies where the cash flow cannot be accurately determined. The error of prediction and assumptions must also be dealt with in the DCF, which we cover with margin of safety.
I’ll go through the many assumptions to consider with a DCF. (If you are considering using the spreadsheets found on this site, please don’t just follow it blindly.)
Free Cash Flow
FCF = Cash from Operations – Capital Expenditure
The number we want to use is the cash generated from ongoing business operations. This is the cash that is recurring and will allow the business to grow. Cash from one time sales of property or a subsidiary should therefore be taken out as it is of low importance compared to the recurring cash.
With the DCF spreadsheet, a reader pointed out that the current FCF formula includes other non cash items and deferred taxes. Since we are looking at cash over different timeframes to normalize the data, I don’t believe it to be a cause of concern. However, as I kept thinking about this, excluding these items would provide a better indication of how the cash has been growing before these additional additions. This would not produce a more conservative number but a better indication of the actual FCF growth.
If we use FactSet Research Systems (FDS) as an example, the median FCF growth over 10 years is 29.8% with the above formula whereas the FCF value minus taxes and other produces a median FCF growth of 34.1%.
A discussion on capital expenditure is a post in itself so I’ll just state that to truly get a better accuracy in your DCF, the amount of maintenence capex and capex used for growth has to be distinguished.
Expected Growth
This is where we get to the artsy side of the DCF and where we have to come up with a number for the indefinite future.
I’ve previously written a qualitative post on growth rates but the growth number I generally use is the median FCF growth over 10 or 5 years depending on the company. I also compare it to the PE since that is what the market expects from the company. The exception is when the FCF growth rate or PE is ridiculously high, which is going to be unsustainable. My cap for the highest growth is limited to 15% to be conservative.
The goal of choosing a growth rate is to find a number which is conservative yet not low balling, and close to reality in order to capture potential future gains without eliminating too many investment candidates.
Discount Rate
Click for the full post on discount rates. As I mentioned in the linked post, I lean very strongly towards present dollars rather than future dollars. In other words, I use a high discount rate because I prefer the certainty of the present cash rather than the uncertainty of the future.
People in the finance world pour out their hearts to obtain the most accurate discount rate by analysing risk free rates, beta, risk premium and WACC. I say rubbish to all this. What’s the point in learning every method of hammering a nail when all you have to do is hit it on the head. Personally, I just believe that people over complicate this aspect.
The beauty of old school Graham and Buffett is that their investments are based on common sense, not volatility and other mumbo jumbo.
Terminal Value
Since it isn’t practical to forecast cash flows for an infinite number of years, it’s usual to end the DCF with a terminal value. On the spreadsheet, the terminal value is 3% (although the text says 5%).
The terminal value can also be found with the stable growth model(pdf), but once again, I personally don’t see the necessity of having to choose between my fixed 3% and 3.4859474% the formula may give.
Discounted Cash Flow
DCF receives a bad rep with the crowd and growth players because they call it driving with the rearview mirror. But in the private business world where estimates and PE’s are absolutely irrelvant, cash is what is used to judge the value of a business.
However, as investors, we all need to have plenty of tools and know which one to apply at the right time. I hope to write about the different valuation methods in the future.
For an idea of the accuracy of a DCF analysis, check out my intrinsic values vs Morningstar’s.
Disclosure
No positions in any stocks at time of writing.
[tags]DCF, discounted cash flow, stock valuation[/tags]
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December 15th, 2008 at 3:31 pm
Very nice write-up. I love DCF models. On a daily basis, emotion drives a stocks price. However, over the long-term, it is expected cash generated that defines its price.
Best Wishes,
D4L
Dividends4Life’s last blog post..Stock Analysis: Donaldson Company, Inc (DCI)
December 15th, 2008 at 10:24 pm
Good post on the importance of discounted cash flow and its use in determining the value of a business.
Mark’s last blog post..Goldman Sachs
December 16th, 2008 at 9:47 am
@D4L,
I too like the DCF because it forces me to think about the cash of the business rather than get caught up with quarterly EPS performance.
@Mark,
thanks
December 26th, 2008 at 7:50 pm
JJ: I like use of free cash flow in DCF models. It gives a realistic value of the business enterprise. PE ratios, EPS, etc are all open to interpretation. FCF is fact – no multiple interpretation…….
Dividend Tree’s last blog post..Market Collision affecting Dividend Investors – Concluding Part
December 27th, 2008 at 10:34 am
Exactly. There are arguments that FCF can also be manipulated and it is true to a small degree, but while manipulation of earnings can go on for several years, the truth always comes out sooner than later if FCF is reworked.
I’m writing a post on FCF at the moment.
March 27th, 2009 at 7:54 am
I notice some investor perform a DCF tied to FCFE (and including dividends) when determining whether to invest. Is this a wrong approach?
July 29th, 2009 at 5:17 am
Hi Jae
Just as an quick teaser, have you ever compared the premium spreadsheet model to that outlined in Hagsrtom’s book, The Warren Buffet Way, on page 126? Both models and up with different valuations by high margins.
All the best
Dave
October 6th, 2009 at 12:24 pm
Hi Jae,
Its a great blog you have here!
I checked the spreadsheet that you offer, and it looks very good. Before buying it, i just wanted to know how do you calculate FCF. I saw that you’re FCF is different from the FCF in morningstar (which is operating CF minus CapEx). what are you subtracting from this to get your FCF?
Thanks!
Ron
October 6th, 2009 at 1:58 pm
@ Ron
I prefer to use the Buffett’s definition of owner earnings which is why i don’t include cash from other operations. I want to know how much cash was generated from the business itself rather than taxes, property and equipment sales etc.
A lot of other income are one time occurrences which means that if you just take it for granted, you’ll be in for a surprise the following year.