Discounted Cash Flow & Stock Valuation

December 14th, 2008 | Comments (12)

The purpose of the Discounted Cash Flow (DCF) method 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.

The advantage of this method is that it requires the investor to think about the stock as a business and analyse 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.


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Discounted Cash Flow

Discounted Cash Flow

Discounted Cash Flow – Not just a discount? | Photo: CGIpromotions

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 and how to effectively use it with the stock valuation calculator.

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 Discounted Cash Flow analysis, check out my intrinsic values vs Morningstar’s.

About Jae Jun


Jae Jun is the founder of Old School Value. He is on a mission to provide practical and actionable value investing tools, tutorials and educational material to help empower the individual investor. Keep in touch with Jae via any of the methods linked below.

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  • http://www.dividends4life.com/ Dividends4Life

    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)

  • http://buylikebuffett.com/ Mark

    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

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

    @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

  • http://dividendtree.blogspot.com/ Dividend Tree

    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

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

    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.

  • Zsolt

    I notice some investor perform a DCF tied to FCFE (and including dividends) when determining whether to invest. Is this a wrong approach?

  • Dave

    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

  • aviad123

    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

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

    @ 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.

  • Financiallogic

    Guys,

    Thanks for this wonderful website. I have a strong doubt in my head and will be glad to hear your thoughts on this. I am not sure if this is the right thread to put this doubt on so please bear with me. Please find below my question –

    For company X, in year 2007:
    • CFO = 50
    • PPE capex = 20
    • Long-term financial investments = 5
    • Sale of equipment = 10
    • New debt raised (and left idle in 2007) = 10
    • New equity raised (and left idle in 2007) = 15
    • Interest paid = 10
    • Dividend paid = 5

    What is FCF, owners earnings, FCFE and FCFF for 2007?

    I ask this question because I have not seen literature that explicitly talks of:
    A. Treatment of Non PPE capex such as long term financial investments when calculating FCFF
    B. Treatment of cash raised in the year under consideration but left idle for the purpose of calculating FCFF

  • Hemanshu Narsana

    Hi Jae, The F Wall Street valuation link doesn’t work.. can you please correct it so that I can read further before seeing if I want to purchase some of your sheets? You have an excellent blog, and I’m really devouring it all!

    If you are in the SFO area I’d love to catch up with you in person when I travel from India for a month!

  • http://www.oldschoolvalue.com/ Old School Value
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