Value stocks

How to use the discounted cash flow model to value stocks

Determining what a company’s stock is worth is easier said than done. The stock market tries to price companies based on their future, but at best it’s still based on little more than educated guesses. A brighter future means a higher valued stock, while a bleaker future means a lower valued stock.

Ultimately, it is the company’s ability to generate cash over time that determines its true value. The discounted cash flow model is a way of estimating the value of stocks based on projections of their future cash flows. Like any other projection, it probably won’t be perfect, but with reasonable assumptions, it can get you close enough to make reasonable buy and sell decisions. With that in mind, here’s a primer on how to use the discounted cash flow model to value stocks.

Image source: Getty Images.

1. Build your estimate of the future

Many companies will provide estimates of how fast they plan to grow over the next few years on their investor relations pages. Others will ask Wall Street analysts to release projections of their potential growth rate. Still others will be silent about their prospects, but will have built a decent track record that can provide clues as to what the future holds.

Whatever source of projections you use, consider that the company’s outlook over time is likely somewhere along an S-curve. For all intents and purposes, this means that when you model its growth , you should expect its growth rate to slow down over time. Sure, it’s possible that the business can continually reinvent itself over time, but growth becomes more difficult on a percentage basis as a business grows. Accordingly, you should not count on perpetual upward growth.

When it comes to modeling the future, many people use a three-step approach. In this method, a common tactic is to assume about five years of rapid growth, about five years of more modest growth, and then a slower perpetual rate of long-term growth thereafter.

A decent guideline to follow is that by the time you get to the perpetual/long-term growth phase, you shouldn’t pick a rate that’s faster than your expected long-term inflation rate. This way, your model won’t be based on a projection that ultimately forces the company to completely dominate multiple industries in the distant future.

2. Determine your discount rate

The discount rate in the discounted cash flow model represents the rate of return you need to bear the risks associated with investing in the business. The higher your discount rate, the lower the fair value calculated by your model. The lower your discount rate, the higher the fair value calculated by your model. This is one of the main reasons why market commentators often argue that when stock prices get too high, future market returns are likely to fall. This is how the calculations work.

As a general rule, your discount rate should be at least as high as your next best alternative use of money. If you think the company is particularly risky, it should be even higher than that. To understand why, flip the logic. If you can invest that money elsewhere for a higher potential risk-adjusted rate of return, why wouldn’t you?

Additionally, for the model’s calculations to work, your discount rate must also always be greater than the perpetual growth rate you use to estimate the company’s long-term future.

Let’s say your discount rate is 10%. Every dollar you expect the business to generate in a year will earn you about $0.91 as you cut it by 10% for a year. The calculation involved is $1/((1+0.1)^1). Similarly, every dollar you expect from the company in two years will earn you about $0.83, since you are reducing it by 10% per year for two years. The calculation involved is $1/((1+0.1)^2).

The end result is that the further into the future you look, the less each projected dollar is worth today. This has the effect of mitigating somewhat the impact that being wrong about the long-term future will have on the value of the company today.

3. Do the math

Once you have the business cash flow estimate and your discount rate, the discounted cash flow model becomes a fairly straightforward mathematical exercise. The table below shows the potential calculations in a three-step model for a company with the following characteristics:

  • $1,000,000 of cash flow in the last year
  • An estimated growth rate of 12% over the next five years
  • An estimated perpetual growth rate of 3%, roughly in line with long-term historical inflation
  • A risk profile where you can justify a 10% discount rate in your model

Year

Projected gross cash flow

Growth rate compared to the previous year

Discounted cash flow

1

$1,120,000

12%

$1,018,182

2

$1,254,400

12%

$1,036,694

3

$1,404,928

12%

$1,055,543

4

$1,573,519

12%

$1,074,735

5

$1,762,342

12%

$1,094,276

6

$1,868,082

6%

$1,054,484

7

$1,980,167

6%

$1,016,139

8

$2,098,977

6%

$979,188

9

$2,224,916

6%

$943,581

ten

$2,358,411

6%

$909,269

Perpetual

$34,702,329

3%

$13,379,250

Estimation of the fair value for the company from the model:

$23,561,342

Author’s calculations.

Add up the total discounted projected cash flows for each year and you get the estimate of your model’s fair value to the business. Divide that by the number of shares outstanding (and possibly adjust for stock dilution over time), and you get what you think is a fair share price for the company you’re considering. For example, if this company had 1,000,000 shares outstanding and no risk of stock dilution, you would estimate its fair value at $23.56 per share.

The row in this table that may seem a bit strange is the row containing the “perpetual” calculation. The math behind this is the Present Value Formula of Growing Perpetuity, also known as Gordon’s Growth Model by dividend investors. The calculation is simply to take the next estimated cash flow and divide it by the difference between your discount rate and your estimated perpetual growth rate.

4. Check your estimates against market assumptions

With your model in hand, you can compare what you calculated with what the market estimates for the company. There is almost a 100% chance that you and the market are not in perfect agreement. It is very good. Indeed, it is differences of opinion that make the market work, because there must be a seller for every stock you are willing to buy (and vice versa).

What the model gives you is a data-driven way to test your assumptions and estimates against how the market values ​​the business. If you make adjustments to your cash flow estimates or your discount rate (or both), you can bring your value closer to market forecasts.

You can then use your model and these adjustments to help you make a better data-driven decision on whether you think the market estimates are closer to the truth or your model estimates. In reality, no one knows for sure who is right until the future unfolds. At this point, your value estimate will need to be updated anyway, depending on the New potential future for the company.

5. Make your decision to invest

Once you have built your model and checked (and/or adjusted) it against market assumptions, you can make a buy, sell or hold decision based on the valuation for any stock you own or plan to own.

For my personal investing, when using a discounted cash flow model, I tend to be willing to buy if the market price of the business is at or below my estimate of fair value. On the other hand, I will generally sell based on valuation only if the market price of the business is quite high beyond so that I keep at least 20% above this estimate after all taxes, commissions and fees. This range gives me leeway to err while potentially benefiting from the company’s long-term growth prospects.

As you build your own patterns and become familiar with how you react to market movements over time, you need to determine your own buy, sell, and hold ranges. Your tolerance for risk, your comfort with volatility and missed opportunities, and your willingness to recognize when your estimates are off should all play a role in your position.

6. Review and adjust your assessment and decisions over time

One of the main benefits of using the discounted cash flow model to value your stocks is that you create a written set of projections when building it. Over time you can check what the company Actually delivered compared to what you valued it would deliver. This gives you the opportunity to revise and adjust your projections and assessment.

It can also give you a warning sign that your investment thesis might end up failing. If the years pass and the projected cash flow never materializes or is well below expectations, it means that the real the value created by the company is much lower than the valued value you thought it would create. It could be a sign that your thesis is broken and it might be time to sell.

Remember that the stock market is always trying to value companies based on their future. So even if his past hasn’t lived up to your expectations, your decision should be based on his new current price compared to your update valuation estimate based on his current set of prospects.

Go ahead and use the discounted cash flow model

With the discounted cash flow model, you have a powerful investment tool that you can use to estimate the fair value of any potential stock. Remember that its calculations are based on projections for the future, and like any projection, it could very well be wrong.

Even with these imperfections, the framework it provides still offers an incredible way to put you in the mindset of a business owner looking to drive value with an investment over time. This mindset can do wonders for your ability to make smart investment decisions no matter what the market is doing at the time. For that alone, the discounted cash flow model deserves a place in your investing arsenal.