Valuation  101:  How  to  do  a  discounted  cashflow  analysis

Sunday,  Jan  22  2012  by  Stockopedia  Features 0  comments  

 
What  is  a  DCF  Valuation?
Discounted   cash   flow   (DCF)   analysis   is   a   method   of   valuing   the   intrinsic   value   of   a   company   (or   asset).   In   simple   terms,
discounted  cash  flow  tries  to  work  out  the  value  today,  based  on  projections  of  all  of  the  cash  that  it  could  make  available  to
investors  in  the  future.  It  is  described  as  "discounted"  cash  flow  because  of  the  principle  of  "time  value  of  money"  (i.e.  cash  in  the
future  is  worth  less  than  cash  today).    

The  advantage  of  DCF  analysis  is  that  it  produces  the  closest  thing  to  an  intrinsic  stock  value  -­  relative  valuation  metrics  such  as
price-­earnings   (P/E)   or   EV/EBITDA   ratios   aren't   very   useful   if   an   entire   sector   or   market   is   overvalued.   In   addition,   the   DCF
method  is  forward-­looking  and  depends  more  on  future  expectations  than  historical  results.  The  method  is  also  based  on  free
cash  flow  (FCF),  which  is  less  subject  to  manipulatio  than  some  other  figures  and  ratios  calculated  out  of  the  income  statement  or  balance  sheet.

DCF  does  however  have  its  weaknesses  as  an  approach.  As  it  is  a  mechanical  valuation  tool,  it  is  subject  to  the  principle  of  "garbage  in,  garbage  out".  In  particular,  small
changes  in  inputs  can  result  in  large  changes  in  the  value  of  a  company,  given  the  need  to  project  cash-­flow  to  infinity.    James  Montier  argues  that,  "while  the  algebra  of  DCF  is
simple,  neat  and  compelling,  the  implementation  becomes  a    minefield  of  problems"  (he  cites,  in  particular,  problems  with    estimating  cash  flows  and  estimating  discount  rates).
Despite  the  issues,  DCF  analysis  is  very  widely  used  and  is  perhaps  the  primary  valuation  tool  amongst  the  financial  analyst  community.  As  part  of  Stockopedia  PRO,   we
provide  pre-­baked  DCF  valuation  models  for  all  stocks,  which  you  can  then  modify  with  your  own  assumptions.

So  how  does  it  work?

In  summary,  the  key  steps  in  a  DCF  analysis  are  as  follows:  

1.   Estimate  Cashflows
2.   Estimate  Growth  Profile  (1  stage,  2  stage,  3  stage  etc)  &  Growth  Rates
3.   Calculate  Discount  Rate
4.   Calculate  the  Terminal  Value
5.   Calculate  fair  value  of  company  and  its  equity  
We  explain  each  of  these  steps  in  more  detail  below.  

1.  How  do  we  estimate  base  cashflow  for  a  DCF?

In  a  DCF  model,  the  first  step  is  to  estimate  how  much  cash  that  the  business  will  generate  and  could  be  paid  to  the  investors.    In  the  strictest  sense,  the  only  cash  flow  that  an
investor   will   receive   from   an   equity   investment   is   the   dividend.   Actual   dividends,   however,   may   be   much   lower   than   the   potential   dividends   because   i)   managers   are
conservative  and  like  to  hold  on  to  cash  to  meet  unforeseen  future  contingencies  and  investment  opportunities.  When  actual  dividends  are  less  than  potential  dividends,  using  a
model  that  focuses  only  on  dividends  will  understate  the  true  value  of  the  equity  in  a  firm.  Some  analysts  assume  that  the  earnings  of  a  firm  represent  its  potential  dividends  but
this  will  typically  over  estimate  the  value  of  the  equity  in  the  firm.  Earnings  are  not  cash  flows,  since  there  are  both  non-­cash  revenues  and  expenses  in  the  earnings  calculation.
This  also  fails  to  take  into  account  the  need  for  a  firm  to  invest  in  new  assets  in  order  to  grow.  

For  that  reason,  the  best  option  is  to  focus  on  free  cash  flow  -­  there  are  two  main  such  definitions:  

i)  Free  Cash  Flow  to  the  Firm  (FCFF).  This  is  the  cash  available  to  bond  holders  and  stock  holders  after  all  expense  and  investments  have  taken  place.  It  is  defined  as:

EBIT    *  (  1  -­  tax  rate)  -­  (Capital  Expenditures  -­  Depreciation)  -­    Change  in  Working  Capital.

ii)  Free  Cash  Flow  to  the  Equity  (FCFE).  This  is  the  cash  is  available  to  pay  to  a  company's  equity  shareholders  after  accounting  for  all  expenses,  reinvestment,  and  debt
repayment.  It  is  defined  as:

Net  Income  -­  (Capital  Expenditures  -­  Depreciation)  -­  Changes  in  non-­cash  Working  Capital  -­  (Principal  Repayments  -­  New  Debt  Issues)  OR  alternatively
Cash  From  Operations  -­  (Capital  Expenditures  -­  Depreciation)    +    Net  Borrowing.

If  we  are  looking  to  value  the  equity,  then  the  most  obvious  option  is  to  use  FCFE.  FCFF  is  preferred  if  the  company  is  unstable  or  has  huge  amount  of  debt  because  the  FCFE
might  be  very  low  or  negative  in  this  case.  Basically,  the  drawback  of  FCFE  is  that  it  will  change  if  the  capital  structure  changes.  That  is,  FCFE  will  go  up  if  the  company  replaces
debt  with  equity  (an  action  that  reduces  interest  paid  and  therefore  increases  CFO)  and  vice  versa.  

2.  How  do  we  forecast  a  company's  cash-­flow  growth  profile?

The  next  step  is  to  estimate  how  fast  will  the  company  grow  its  free  cash  flow.  This  is  a  critical  part  of  any  valuation  and  is  typically  where  the  biggest  errors  creep  in.  People
tend  to  overestimate  how  fast  a  company  can  grow.  First,  we  need  to  decide  whether  how  many  different  stages  of  growth  the  DCF  will  have.  A  1  stage  DCF  model  would  be
used  for  a  company  expected  to  see  consistent  stable  growth.  The  prevalent  form  of  the  DCF  model  in  practice  is  the  two-­stage  DCF  model  -­  this  involves    an  explicit  projection
of  free  cash  flows  generally  for  5-­10  years,  following  which  a  terminal  terminal  value  is  calculated  to  account  for  all  the  cash  flows  beyond  the  forecast  period  -­  but  a  more
involved  3+  stage  DCF  model  could  also  be  used.  

Once  this  is  decided,  there  are  three  basic  ways  of  estimating  growth  for  any  firm:

i)  Extrapolate  from  historic  growth  -­  One  option  is  to  use  historic  growth  rates,  but  unfortunately  these  rates  tend  to  have  considerable  noise  associated  with  them.  In  an  study
of  the  relationship  between  past  growth  rates  and  future  growth  rates,  Little  (1960)  coined  the  term  'Higgledy  Piggledy  Growth"  because  he  found  little  evidence  that  firms  that
grew  fast  in  one  period  continued  to  grow  fast  in  the  next  period.  In  addition,  measurement  is  not  straightforward  -­  growth  rates  can  be  different  depending  the  period  selected  or
they  may  be  complicated  by  the  presence  of  negative  earnings.  

ii)  Trust  the  Analysts  -­  The  second  approach  is  to  trust  the  equity  research  analysts  that  follow  the  firm  to  come  up  with  the  right  estimate  of  growth  for  the  firm,  and  to  use  that
growth  rate  in  valuation.  However,  the  evidence  suggests  that  analysts  are  very  poor  forecasters,  especially  over  the  long-­term.  Work  by  James  Montier  found  that  the  average
24-­month  forecast  error  is  around  94%,  and  the  average  12-­month  forecast  error  is  around  45%.

iii)  Fundamental  Determinants  -­  With  both  historical  and  analyst  estimates,  growth  is  treated  as  an  exogenous  variable  that  affects  value  but    is    divorced    from    the    operating  
details    of    the    firm.    As  Professor  Damodaran  notes,  the  alternative  way  of  incorporating  growth  into  value  is  to  make  it  endogenous,  i.e.,  to  make  it  a  function  of  how  much  a
firm  reinvests  for  future  growth  and  the  quality  of  its  reinvestment.  When  a  firm  has  a  stable  return  on  capital,  its  expected  growth  in  operating  income  (and  therefore  cashflow)  is
a  product  of  the  reinvestment  rate,  i.e.,  the  proportion  of  the  after-­tax  operating  income  that  is  invested  in  net  capital  expenditures  and  non-­cash  working  capital,  and  the  quality
of  these  reinvestments,  measured  as  the  return  on  the  capital  invested.  The  formula  is:

Reinvestment  Rate  *  Return  on  Capital  where  Reinvestment  Rate  =  Capital  Expenditure    -­  Depreciation    +    Change  in  Non-­cash  WC  and  Return  on
Capital  =  EBIT  (1-­t)  /  Capital  Invested

Option  iii)  is  probably  the  best  option  but  may  feel  a  bit  involved.  A  simpler  approach  would  be  to  look  at  historic  growth  over  the  past  several  years,  take  an  average,  and  then
reduce  that  in  stages.  A  three-­stage  model  might  take  the  last  3-­years'  growth  rate,  apply  it  to  the  next  five  years,  chop  it  in  half  for  the  next  five  years,  and  then  reduce  it  to  3%
(the  long  term  rate  of  inflation,  e.g.  no  "real"  growth)  from  then  on.

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3.  How  do  we  choose  a  discount  rate?

Having  projected  the  company's  free  cash  flow  for  the  next  X  years,  we  need  an  appropriate  discount  rate  which  we  can  use  to  calculate  the  net  present  value  (NPV)  of  the  cash
flows.  This  is  a  critical  ingredient  in  discounted  cashflow  valuation.  Errors  in  estimating  the  discount  rate  or  mismatching  cashflows  and  discount  rates  can  lead  to  serious  errors
in  valuation.  It  is  important  that  the  Discount  Rate  should  be  consistent  with  the  cash  flow  being  discounted.  If  the  cash  flows  being  discounted  are  cash  flows  to  equity,  the
appropriate  discount  rate  is  a  cost  of  equity.  If  the  cash  flows  are  cash  flows  to  the  firm,  the  appropriate  discount  rate  is  the  cost  of  capital  (or  WACC  -­  the  weighted  average  cost
of  capital).

Cost  of  Equity    

Equity  shareholders  expect  to  obtain  a  certain  return  on  their  equity  investment  in  a  company.  From  the  company's  perspective,  the  equity  holders'  required  rate  of  return  is  a
cost.   However,   unlike   the   cost   of   debt   which   is   relatively   easy   to   determine   from   observation   of   interest   rates   in   the   capital   markets,   a   company's   current   cost   of   equity   is
unobservable  and  must  be  estimated.    

CAPM
There  are  various  models  for  doing  so,  the  most  commonly  accepted  of  which  is  the  Capital  Asset  Pricing  Model,  or  CAPM  where:

Cost  of  Equity  (Re)  =  Risk  Free  Rate  (Rf)  +  Beta  *  Equity  Risk  Premium.  

To  explain  these  terms:

i)  Risk-­Free  Rate  -­  This  is  the  amount  obtained  from  investing  in  securities  considered  free  from  credit  risk,  such  as  US  government  bonds.

ii)  ß  -­  Beta  -­  This  measures  how  much  a  company's  share  price  moves  against  the  market  as  a  whole.  A  beta  of  one,  for  instance,  indicates  that  the  company  moves  in  line  with
the  market.  If  the  beta  is  in  excess  of  one,  the  share  is  amplifying  the  market's  movements;;  less  than  one  means  the  share  is  more  stable.  

iii)  Equity  Market  Risk  Premium  -­  The  equity  market  risk  premium  represents  the  returns  investors  expect,  over  and  above  the  risk-­free  rate,  to  compensate  them  for  taking
extra  risk  by  investing  in  the  stock  market.  In  other  words,  it  is  the  difference  between  the  risk-­free  rate  and  the  market  rate.  Practitioners  never  seem  to  agree  on  the  premium;;  it
is  sensitive  to  how  far  back  you  go  in  history,  what  bonds  you  use  as  a  reference  point,  and  whether  you  use  geometric  or  arithmetic  averages.

While  widely  used,  CAPM  has  been  widely  criticised  as  being  empirically  flawed  -­  according  to  Montier,  "CAPM  woefully  under  predicts  the  returns  to  low  beta  stocks,  and
massively  overestimates  the  returns  to  high  beta  stocks.  Over  the  long  run  there  has  been  essentially  no  relationship  between  beta  and  return"  -­  as  well  as  being  based  on  a
highly   unrealistic   set   of   assumptions.   For   that   reason,   it   may   be   better   to   just   adopt   a   discount   rate   that   seems   intuitively   consistent   with   both   the   riskiness   and   the   type   of
cashflow  being  discounted.

Interestingly,  Buffett  uses  something  like  the  thirty-­year  U.S.  treasury  bond  rate  but  without  a  risk  premium  on  the  basis  that  he  avoids  risks.  "I  put  a  heavy  weight  on  certainty.    If
you  do  that,  the  whole  idea  of  a  risk  factor  doesn't  make  any  sense  to  me.  Risk  comes  from  not  knowing  what  you're  doing."  (although,  presumably,  as  a  value  investor,  he
builds  a  significant  margin  of  safety  elsewhere).  

4.  How  do  we  calculate  the  Terminal  Value?

Instead  of  trying  to  project  the  cash  flows  to  infinity,  terminal  value  techniques  are  used.  One  way  of  calculating  the  terminal  value  (TV)  is  by  using  the  Gordon  Growth  Model,
which  essentially  assumes  that  company's  cash  flow  will  stabilize  after  last  projected  year  and  will  continue  at  the  same  rate  forever.  Here  is  the  formula:

Final  Projected  Year  Cash  Flow  X  (1+Long-­Term  Cash  Flow  Growth  Rate)  /  (Discount  Rate  –  Long-­Term  Cash  Flow  Growth  Rate).

Another  possibility  of  determining  terminal  value  of  the  company  is  to  use  multipliers  of  income  or  cash  flow  measures  (net  income,  net  operating  profit,  EBITDA,  operating  cash
flow  or  FCF),  which  are  determined  with  reference  to  comparable  companies  on  the  market.  

The  TV  often  represents  a  large  percentage  of  the  total  DCF  valuation.  As  Montier  notes:

"If    we  assume  a  perpetual  growth  rate  of  5%  and  a  cost  of  capital  of  9%  then  the  terminal    multiple  is  25x.  However,  if  we  are  off  by  one  percent  on  either
or  both  of  our  inputs,  then    the  terminal  multiple  can  range  from  16x  to  50x!".

Valuation,  in  such  cases,  can  unfortunately  become  largely  dependent  on  TV  assumptions  rather  than  operating  assumptions  for  the  business  or  the  asset.  

Calculate  Fair  Value  of  Company  &  Equity

To  arrive  at  a  total  company  value,  or  enterprise  value  (EV),  we  simply  have  to  take  the  present  value  of  the  cash  flows  and  the  Terminal  value,  divide  them  by  the  discount  rate
and,  finally,  add  up  the  results.  If  we  are  discounting  FCFE  at  the  cost  of  equity,  this  will  give  the  value  of  the  equity.  If  we  are  discounting  FCFF  at  the  weighted  average  cost  of
capital,  this  would  give  the  value  of  the  firm,  so  it  would  be  necessary  to  deduct  net  debt  in  order  to  arrive  at  the  equity  value.  

Conclusions
Although  Montier  argues  that  DCF  "should  be  consigned  to  the  dustbin  of  theory,  alongside  the  efficient  markets  hypothesis,  and  CAPM",  this  seem  a  little  harsh.  It  is  a  useful
tool,  provided  that  its  constraints  are  clearly  understood  (e.g.  the  sensitivity  to  inputs),  and  it  is  best  used  with  other  tools  such  as  Earnings  Power  Value  and  Relative  Value
techniques  as  a  sense  check.  In  order  to  use  DCF  most  effectively,  the  target  company  should  generally  have  positive  and  predictable  free  cash  flows  (i.e.  typically  it's  best  with
mature  firms  that  are  past  the  growth  stages).  DCF  works  less  well  when  a  company's  operations  lack  "visibility"  -­  i.e,  when  it's  difficult  to  predict  revenue  and  cost  trends  with
much  certainty.  DCF  analysis  also  demands  vigilance  so  if  Company  X  delivers  disappointing  quarterly  results,  or  if  interest  rates  change  dramatically,  you  may  need  to  adjust
your  assumptions.  

Further  Reading
Wikipedia  on  Discounted  Cashflow  
What  is  Free  Cash  Flow  and  how  do  I  calculate  it?  
 Investopedia  on  Discounted  Cashflow
Estimating  Cashflows
Macabacus  on  DCF
Schweser  Notes  on  FCF  Valuation

Filed  Under:  Valuation,

There's  value  in  the  stock  market

but  do  you  know  where  to  look?
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that's  been  proven  to  work  in  value  investing.
If  you  like  your  stocks  cheap  you've  found  a
treasure  trove  distilled  to  under  70  pages.

How  to  find  ultimate  Bargain  Stocks  with  Ben  Graham

How  to  spot  Turnarounds  and  avoid  Value  Traps
From  Graham  to  Greenblatt  via  Piotroski  &  Lakonishok
How  to  value  stocks  and  set  a  margin  of  safety

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