stock valuation models

Stock Valuation Models: DCF & DDM (Part 1)

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Stock Valuation Models: DCF

What stock to buy now? Should I invest in Tesla, NIO, or Ford? Rather than searching for answers on what stocks to buy and getting answers from dubious sources online, why not learn how to choose the right stocks yourself? 

With a handful of key stock valuation models at your disposal and some practice, you could pick up the important skill of equity valuation, which can be beneficial for a lifetime. 

In another article, we have listed the metrics used to determine the relative value of a company, which is useful when comparing it against its other firms.

In this article, we will cover the formulas that calculate the intrinsic value of a company, which can be compared with its market value to determine whether an investment is profitable.

Intrinsic Value of Company > Market Value of Company = Company is Undervalued

Intrinsic Value of Company < Market Value of Company = Company is Overvalued

This guide will walk you through one of the most fundamental stock valuation models you will need to determine a stock’s intrinsic value and if it is undervalued or overvalued relative to its current market value.

Known as the Discounted Cash Flow (DCF) analysis, almost all other valuation methods are built upon this one.

This is Part 1 of a 2 parts series. You can find Part 2 in this link where we talk about the Discounted Dividend Model (DDM)

Key Stock Valuation Model: Discounted Cash Flow (DCF)

Discounted cash flow (DCF) is one of the most comprehensive and widely-used stock valuation models in finance. Its purpose is to estimate the current value of an investment based on its expected future cash flows. 

The DCF stock valuation model estimates the intrinsic value of a company using its cash flow and is often presented in comparison to the company’s market value.

Understanding Present Value

The underlying principle behind DCF is that an investment is worth as much as its future cash flows but adjusted for the time value of money, or discounted to the present value.

In simple terms, you need to discount the cash flows because money today is worth more than money in the future. But why?

Suppose someone were to offer you a $100 bill but gave you an option of taking it today or 5 years later. Most people would choose the former. One intuition is that with inflation, a $100 bill may not be worth as much in 5 years. You may also reason that if you put the $100 bill in a savings account or some sort of investment, its value will increase in five years.

This is the fundamental principle behind how the discounted cash flow (DCF) stock valuation model attempts to figure out how much an investment is worth today, based on projections of how much money it will generate in the future.

How do you calculate DCF?

There are 3 steps to calculating the DCF of an investment.

  1. Estimate the expected (future) cash flows of the investment
  • Determine a discount rate, usually based on the cost of financing the investment or the opportunity cost presented by alternative investments
  • Use tools like an excel spreadsheet or manual calculation to discount the predicted cash flows back to the present day to derive the intrinsic value of the investment.

The formula for Discounted Cash Flow (DCF)

Stock valuation models (discounted cash flow formula)

Where:

  • CF = projected cash flow for each year (CF1 is for year 1, CF2 is for year 2, etc.)
  • r = discount rate in decimal form

Note: There is a wide range of formulas used for DCF analysis outside of this simplified one, depending on what type of investment is being analyzed and what financial information is available. This formula showcases the general reasoning behind the DCF stock valuation model.

Let’s break it down.

Step 1: Estimate the expected cash flows of the investment

Stock valuation models (step 1: estimating free cash flow)

Free cash flow is the net amount of cash a company brings in. Usually, you can obtain the past cash flow data of a company from online sources automatically, or you can calculate it manually from financial statements collated by platforms such as Yahoo! Finance.

The generic free cash flow is the total cash flow from operations minus capital expenditures.

Up until this stage, you have only obtained the company’s historical cash flows. The real challenge from this point onwards is to estimate what the future cash flows are like for this company, based on your take on the company’s fundamentals and future trajectory. Here is where stock valuation becomes more of an art than a science.

Example of Free Cash Flow Calculation

Derive the free cash flow of a company by looking at its financial statement. Below is an example using Macy’s Inc. (M), the US’s top department store chain.

Macy’s cash flow statement for the fiscal year ending 2021, according to the company’s 10K statement, provides this information:

  1. Cash Flow From Operating Activities = $1.246 billion
  2. Capital Expenditures = $0.465 billion

Macy’s 2021 Free Cash Flow = $1.246 billion−$0.465 billion = $781 million

Macy’s has a large amount of free cash flow, which can be used for dividends payouts, expansion of operations, and paying off debt.

From 2012 till now, Macy’s capital expenditures, however, have been increasing due to its growth in stores, while its operating cash flow has been decreasing, resulting in decreasing free cash flows.

Stock Valuation models (Macy's Free Cash Flow trend)
Source: Stock Rover

Implications Of Shrinking Free Cash Flow

A decreasing free cash flow may be a sign that the firm is unable to sustain earnings growth. This may force companies to increase debt levels or not have the liquidity to stay in business. 

That being said, a shrinking FCF is not necessarily a bad thing, particularly if increasing capital expenditures are being used to invest in the growth of the company, which could increase revenues and profits in the future.

Step 1.5: Choose A Terminal Value

DCF has two major components: forecast period and terminal value.

Up till now, we have talked about forecasting the future cash flows of a company.

However, realistically, the forecast period is about five years, and occasionally 10 years. This is because forecasting gets murkier as the time horizon grows longer. When predicting a company’s cash flows well into the future, your estimations become increasingly less accurate. 

This is where terminal value becomes important. 

Terminal value (TV) determines a company’s value into perpetuity beyond a set forecast period — usually ten years. 

The DCF valuation of a business is simply the sum of the discounted projected Free Cash Flow amounts (for 10 years), plus the discounted Terminal Value amount.

Note: If the Perpetuity Method is used, the discount rate from the next step (step 2) will be needed. 

How To Calculate Terminal Value

Stock valuation models (Terminal value calculation - perpetuity method)
Source: Corporate Finance Institute

There are two methods used to calculate terminal value: perpetual growth and exit multiple

Perpetuity Method

The perpetual growth model works under the assumption that cash flows will grow at a stable rate into perpetuity (forever), starting at a certain point in the future. 

Terminal value is calculated by dividing the last cash flow forecast by the difference between the discount rate and terminal growth rate. The terminal value calculation estimates the value of the company after the forecast period.

The formula to calculate terminal value is:

Stock valuation models (Formula to calculate terminal value)

Where:

  • FCF = Free cash flow for the last forecast period 
  • g = Terminal growth rate 
  • r = Discount rate (which is usually the WACC)

The terminal growth rate g is the constant rate that a company is expected to grow at forever. This growth rate starts at the end of the last forecasted cash flow period in a discounted cash flow model and goes into perpetuity. 

A terminal growth rate is usually in line with the long-term rate of inflation, but not higher than the historical gross domestic product (GDP) growth rate of the country.  

Exit Multiple Method

The exit multiple models assume that a business will be sold for a multiple of some market metric. This is the method favored by investment professionals.

Exit multiples estimate a fair price by multiplying financial statistics, such as sales, profits, or earnings before interest, taxes, depreciation, and amortization (EBITDA) by a factor that is common for similar firms that were recently acquired (usually an average of recent exit multiples for other transactions). 

The formula to calculate terminal value is:

Stock valuation models (Terminal value calculation - exit multiple method)

Example Of Exit Multiple Calculation

  1. Identify a reasonable EBITDA multiple ranges. For this example, we assume a range of 6.0x EV/EBITDA. We chose 6.0x based on historical trading ranges for the company along with comparable companies in the industry.
  2. Multiply the EV/EBITDA multiple ranges by the end of the period EBITDA estimate.

Year 6 EBITDA = $13,367

EV/EBITDA Multiple Range = 6.0x

Terminal Value = $13,367 × [6.0x] = $80,203

Stock valuation models (Terminal value calculation - exit multiple method 2)

This concludes the first step of the Discounted Cash Flow Stock Valuation Model. At this point, you have learned how to estimate the future cash flows of the company, which is arguably the most important step in any DCF analysis.

Step 2: Choose a Discount Rate, r

Stock valuation models (Discount Rate)

Once you have determined a good estimation of the company’s cash flows for the next few years (Step 1), and an appropriate terminal value (Step 1.5), the next step is to pick a discount rate. The discount rate is typically represented by the cost of capital, such as the interest rate. It needs to reflect the “riskiness” of an investment.

For business valuation purposes, a firm’s Weighted Average Cost of Capital (WACC) is commonly used as a discount rate. This information can usually be obtained online.

WACC accounts for the firm’s financing costs of equity and debt and is considered to represent the opportunity cost of funds used. It represents the rate of return that investors expect from investing in the company.

Weighted Average Cost Of Capital (WACC)

When the WACC of a company cannot be found online, we have to derive it manually using a formula. 

Understanding Weighted Average Cost Of Capital

WACC can be a confusing concept to understand. If you are not interested in getting into the details, you can skip to the formula below.

The formal definition of WACC is the required rate of return for the entire business for the risks investors bear when they invest in the company. 

On the other hand, the layman’s definition of WACC is the discount rate used to discount projected Free Cash Flows in a DCF model, as stated above.

These definitions are the same. If an investor requires a specific return on his investment dollars today, then future cash flows from an investment he makes can be converted into today’s dollars using that required rate of return. 

This is the present value for future cash flows. The WACC does this for all investors in a company, weighted by their relative size. How then do we determine what that required rate of return should be?

This discount rate should be a function of the best alternative investment opportunities available to the investors, and the riskiness of making that investment in the company relative to those available alternative returns

For example, if the risk-equivalent return in other opportunities is 10% per year, then an investor should require a 10% return from this investment as well. And so to determine the present value of the investment, we need to discount all future benefits (cash flows) by 10%.

This is the formula of WACC:

Stock valuation models (WACC)

E = Value of Equity or market cap of the company

D = Value of Debt or total amount of debt on its balance sheet

re = Cost of Equity, found using the CAPM model (more on that later)

rd = Cost of Debt, weighted average cost of interest payment on debt obligations

t = corporate tax rate

Most of the data in the WACC formula can be easily sourced with the exception of re which is the Cost of Equity. One way of calculating its value is through the Capital Asset Pricing Model or CAPM model for short. re considers the risk you are taking on and how much you could make elsewhere.

Formula for CAPM

Stock valuation models (CAPM)

The yields of super-safe 10-year US government bonds are typically used as the risk-free rate of return, Krf. The historical market risk premium (RP) is how much extra the stock market overall tends to deliver above that risk-free rate. Using a long-term average, that risk premium is typically around 6.5%

Beta (b) measures the volatility of the stock you are valuing – it’s a proxy for how risky it is compared to the wider market, helping you figure out what your compensation should be for taking on the risk of that particular stock. For example, a tech stock like Tesla will have a Beta that is significantly more than 1.0 (more volatile than the broader market) while a consumer staple stock such as Walmart will have a Beta that is less than 1.0 (less volatile than the market).

Calculation of WACC

Assuming you have the following Beta of market risk premium information of a stock: Beta = 1.035 (slightly more volatile than the market) and RP = 8.0%. Your WACC calculation is illustrated below

Stock valuation models (Calculation of WACC)

In this case, our discount rate would be 0.105 or 10.5%

Step 3: Calculate the DCF

To recap, in Step 1, we estimate the CF of the company and its associated Terminal value.

In Step 2, we calculated the WACC or the discount rate of the counter.

Stock valuation models (Calculation of DCF)

Step 3 is essentially to apply the formula as shown above, adding the discounted value of each future cash flow to the company’s discounted terminal value. This final step can typically be calculated with the help of an Excel sheet

After these 3 steps, there is one final step that determines whether you should invest – compare your result with the current share price of the investment.

Stock valuation models (Value of a share)

The true value of a share of the stock can be roughly estimated by dividing the sum of all the future cash flows (discounted to the present year) by the total number of shares issued.

If the DCF shows that the true value is above the current price of the investment, the investment may be worthy as the intrinsic value is greater than the market value; if the opposite is true, the investment will likely yield negative returns as the real value is lower than the market value.

Key Assumptions used during DCF Valuation

Below are the key assumptions that one would need when it comes to valuing a counter using the DCF Stock Valuation Model.

  1. The growth rate of the company’s free cash flow
  2. The Discount Rate for discounting the company’s future cash flows back to the present value. In our example, we are using the WACC
  3. Terminal Growth Rate for calculation of the company’s terminal value

As can be seen, the assumptions used can be rather subjective. If the assumptions used are “garbage” you will similarly derive a “garbage” value that could be extremely erroneous.

Various Limitations About Discounted Cash Flow

An interesting thing to note about the DCF valuation model is that almost all of its components are made up of assumptions or estimations as highlighted earlier.

For one, an investor would have to forecast the future cash flows from an investment. This is not an easy feat. Future cash flows are dependent on a mixture of complications, such as market sentiment, the state of the economy, technology, competition, and unforeseen threats or opportunities.

Estimate future cash flows to be too high, and risk making an investment that might not pay off in the future. But estimate cash flows to be too low, and risk missing good opportunities. 

Another limitation pertains to generating the intrinsic value of a company that does not generate any free cash flow at present. This might be the case for many hyper-growth loss-generating stocks which are also cash-burners.

Picking a discount rate for the model is also an assumption, one that makes a huge impact on the overall decision. A 1% uncertainty may mean the difference between buying or selling. 

That being said, this does not render the DCF model incorrect or unreliable – the best physicists frequently use estimations and assumptions even in the context of cold hard science. As successful investors from Keynes to Buffett and Munger have repeated often: “it is better to be approximately correct, as opposed to precisely wrong.”

It is difficult to find a universal DCF calculator or spreadsheet model that you can just plug values into. The heavy reliance on estimations and intuition is why the DCF model differentiates good stock analysts from mediocre ones.

We will talk about the Dividend Discount Model or DDM for short in Part 2 of this 2-parts article on Stock Valuation Models.

Disclosure: The accuracy of the material found in this article cannot be guaranteed. Past performance is not an assurance of future results. This article is not to be construed as a recommendation to Buy or Sell any shares or derivative products and is solely for reference only

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