How to use the discounted cash flow model to value stocks
Determining the value of a company’s stock is easier said than done. The stock market tries to value companies based on their future, but at best it’s always based on educated guesses. A brighter future means a more valued stock, while a darker future means a less valued stock.
Ultimately, it is the company’s ability to generate cash over time that determines its real value. The discounted cash flow model is a way to estimate the values 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 an introduction on how to use the discounted cash flow model to value stocks.
1. Build your estimate of the future
Many companies will provide estimates of how fast they expect to grow over the next several 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 outlook, but will have built a decent track record that can provide clues as to what the future will bring.
Whichever source of projections you use, consider that the outlook for the business over time is likely to be somewhere along an S-curve. For all intents and purposes, that means when you model its growth , you should expect its growth rate to slow down over time. Of course, it is possible for the business to continually reinvent itself over time, but growth becomes more difficult in percentage terms as the business grows. As a result, one should not count on perpetual growth to the sky.
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 growth rate over the long term.
A decent guideline to follow is that by the time you get to the perpetual / long-term growth phase, you shouldn’t choose a rate faster than your expected long-term inflation rate. This way, your model will not be based on a projection which would otherwise force the company to completely dominate several 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 assume 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 claim that when stock prices get too high, future market returns are likely to fall. This is just how math works.
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 business is particularly risky, it should be even higher than that. To understand why, flip the logic. If you can invest that money somewhere else to get a higher risk-adjusted potential rate of return, why wouldn’t you?
Additionally, for the mathematics of the model to work, your discount rate must also always be greater than the perpetual growth rate that you use to estimate the long-term future of the business.
Let’s say your discount rate is 10%. Every dollar you’d expect the business to make in a year would be worth around $ 0.91 to you because you’re cutting it 10% for a year. The calculation used is $ 1 / ((1 + 0.1) ^ 1). Likewise, every dollar the business is expected to make in two years would be worth about $ 0.83 to you, since you are reducing it by 10% per year for two years. The calculation used is $ 1 / ((1 + 0.1) ^ 2).
The end result is that the further into the future you look, the less every dollar projected is worth today. This has the effect of mitigating a little 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 estimate of the company’s cash flow and your discount rate, the discounted cash flow model becomes a fairly straightforward mathematical exercise. The table below shows the potential math in a three-step model for a business with the following characteristics:
- $ 1,000,000 in cash flow over the past year
- An estimated growth rate of 12% over the next five years
- Perpetual growth rate estimated at 3% – roughly in line with historic long-term inflation
- A risk profile where you can justify a 10% discount rate in your model
Year |
Projected gross cash flows |
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 of the company from the model: |
$ 23,561,342 |
Add up the total discounted forecast cash flows for each year and you get your model’s fair value estimate to the business. Divide that by the number of shares outstanding (and potentially adjust the dilution of the shares 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 dilution of the shares, you would estimate its fair value to be $ 23.56 per share.
The row of this table which may seem a little strange is the row containing the “Perpetual” calculation. The calculation behind this is the present value formula of increasing perpetuity, also known as the Gordon 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 business. There is almost a 100% chance that you and the market are not in perfect agreement. It is very good. This is because it is differences of opinion that make the market work, as there has to 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 company. If you make adjustments to your cash flow estimates or your discount rate (or both), you can bring your value closer to what the market predicts.
You can then use your model and those adjustments to help you make a better data-based decision about whether you think the market estimates are closer to the truth or your model’s 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 future potential of the company.
5. Make your investment decision
Once you’ve built your model and checked (and / or adjusted) it against market assumptions, you can make a valuation-based buy, sell, or hold decision for any stock you own or plan to own.
For my personal investments, when I use a discounted cash flow model, I tend to be prepared to buy if the market price of the business is at or below my estimate of fair value. On the other hand, I will usually 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 allows me to get it wrong while potentially taking advantage of the company’s long-term growth prospects.
As you build your own models and become more 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 ease with volatility and missed opportunities, and your willingness to recognize when your estimates are wrong should all play a role in the position they give you.
6. Review and adjust your assessment and decisions over time
One of the main advantages of using the discounted cash flow model to value your stocks is that you create a written set of projections when you build it. Over time, you can check what the company in fact delivered compared to what you valued he would deliver. This gives you the opportunity to revise and adjust your projections and your assessment.
It can also give you a warning sign that your investment thesis could end up failing. If the years go by and the projected cash flow never materializes or is well below expectations, it means 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 maybe it’s time to sell.
Remember that the stock market is always trying to value companies based on their future. So even if his past has not lived up to your expectations, your decision should be based on his new stream price compared to your update valuation estimate based on its current set of outlook.
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 may 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 generate value with 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 investment arsenal.