Figuring out what a company's shares are worth is easier said than done. The stock market attempts to value businesses based on their futures, but at best, it's still based on little more than educated guesses. A brighter future means a more highly valued stock, while a dimmer future means a lower valued one.
Ultimately, it's the company's ability to generate cash over time that determines what it's really worth. The discounted cash flow model is a way to estimate values for stocks based on projections for 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.
1. Build your estimate of the future
Many companies will provide estimates of how fast they expect to grow over the next few years on their investor relations pages. Others will have Wall Street analysts publish projections for their potential growth rate. Still others will be quiet about their prospects, but will have built decent track records that can provide clues for what the future will bring.
Whatever source of projections you use, consider that the company's prospects over time probably sit somewhere along an S curve. For all practical purposes, that means as you're modeling out its growth, you should expect its growth rate to slow down over time. Sure, there's a chance that the company can continually reinvent itself over time, but growth gets tougher on a percentage basis as a company gets bigger. As a result, you shouldn't count on perpetual growth to the sky.
When it comes to modeling out the future, many people use a three-stage approach. In that method, a common tactic is to assume five or so years of rapid growth, five or so years of more modest growth, and then a slower perpetual growth rate for the long haul after that.
A decent guideline to follow is that by the time you get to the perpetual/long-run growth phase, you shouldn't pick a rate any faster than your long-run expected inflation rate. That way, your model won't be based on a projection that would ultimately otherwise require the company to completely dominate multiple industries in the distant future.
2. Figure out your discount rate
The discount rate in the discounted cash flow model represents the rate of return you need in order to take on the risks associated with investing in the company. The higher your discount rate, the lower the fair value your model will calculate. The lower your discount rate, the higher the fair value your model will calculate. This is a key reason why market commentators often claim that when stock prices get too high, future market returns will likely drop. That's just how the math works out.
As a general rule, your discount rate should be at least as high as your next best alternative use of the money. If you think the company is particularly risky, it should be even higher than that. To understand why, flip the logic around. If you can invest that money somewhere else for a higher risk-adjusted rate of potential return, why wouldn't you?
In addition, to make the model's math work out, your discount rate should also always be higher than the perpetual growth rate you're using in estimating company's long-term future.
Say your discount rate is 10%. Every dollar you expect the company to generate a year from now would be worth around $0.91 to you, because you're discounting it by 10% for one year. The math involved is $1/((1+0.1)^1). Similarly, every dollar you expect the company to generate two years from now would be worth around $0.83 to you, since you're discounting it by 10% per year for two years. The math involved is $1/((1+0.1)^2).
The end result is that the further in the future you look, the less each projected dollar is worth today. That has the effect of tamping down a bit on the impact that being wrong about the long-term future will have on the company's value today.
3. Do the math
Once you have the estimate of the company's cash flows and your discount rate, the discounted cash flow model becomes a fairly straightforward math exercise. The table below shows the potential math in a three-stage model for a company with the following characteristics:
$1,000,000 in cash flows over the past year
An estimated 12% growth rate over the next five years
An estimated perpetual growth rate of 3% — about in line with historical long run inflation
A risk profile where you can justify a 10% discount rate in your model
Raw Projected Cash Flows
Growth Rate vs. Prior Year
Discounted Cash Flows
Fair Value Estimate for the company from the model:
Add up the total of each year's discounted projected cash flows, and you get your model's fair value estimate for the company. Divide that by the number of shares outstanding (and potentially adjust for stock dilution over time), and you get what you believe to be a fair stock price for the company you're considering. For instance, if this company had 1,000,000 shares outstanding and no stock dilution risk, you'd estimate its fair value to be $23.56 per share.
The line in that table that might seem a bit odd is the row with the “Perpetual” calculation in it. The math behind that is the formula for the present value of a growing perpetuity, also commonly known as the Gordon Growth Model by dividend investors. The math is to simply 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 versus the market's assumptions
With your model in hand, you can compare what you've calculated with what the market is estimating for the company. Chances are virtually 100% that you and the market will not be in perfect agreement. That's just fine. Indeed, differences of opinion are what make the market work, as there needs to be a seller for every share you're willing to buy (and vice versa).
What the model gives you is a data-based way to test your assumptions and estimates against how the market is valuing the company. If you make adjustments to either your cash flow estimates or your discount rate (or both), you can get your value closer in line with what the market is projecting.
You can then use your model and those adjustments to help yourself make a better data-based decision as to whether you believe the market's estimates are closer to the truth or your model's estimates. In reality, nobody knows for certain who's right until the future unfolds. By that point, your value estimate would need to be updated anyway, based on the new potential future for the company.
5. Make your investing decision
Once you've built your model and checked it (and/or adjusted it) against the market's assumptions, you can make a valuation-based buy, sell, or hold decision for any stock you own or are considering owning.
For my personal investing, when using a discounted cash flow model, I tend to be willing to buy if the company's market price is at or below my fair value estimate. On the flip side, I generally will sell based on valuation only if the company's market price is high enough beyond it so that I keep at least 20% above than that estimate after all taxes, commissions, and fees. That range gives me some room to be wrong while still potentially profiting from the company's long-term growth prospects.
As you build your own models and your own familiarity with how you respond to market moves over time, you should determine your own buy, sell, and hold ranges. Your risk tolerance, comfort with volatility and missed opportunities, and willingness to recognize when your estimates are wrong all should play a role in where they sit for you.
6. Review and adjust your valuation and decisions over time
A key benefit of using the discounted cash flow model to value your stocks is that you create a written set of projections when building it. As time passes, you can check what the company actually delivered compared to what you estimated it would deliver. That gives you a chance to revise and adjust your projections and valuation.
It can also give you a warning sign that your investing thesis might wind up busted. If years pass and the projected cash flows never materialize or come in well below expectations, it means the actual value created by the company is well below the estimated value you thought it would create. That could be a sign that your thesis is broken and it might be time to sell.
Still, remember that the stock market always attempts to value companies based on their futures. So even if its past hasn't lived up to your expectations, your decision should be based on its new current price verus your updated valuation estimate based on its current set of prospects.
Go forth and use the discounted cash flow model
With the discounted cash flow model, you have a powerful investing tool that you can use to estimate a fair value for any potential stock. Just remember that its math is based on projections for the future, and like any projection, it can very well be wrong.
Even with those imperfections, the framework it provides still provides an incredible way to get you in the mindset of a business owner looking to generate value with an investment over time. That mindset can do wonders for your ability to make intelligent investing decisions, no matter what the market happens to be doing at the time. For that alone, the discounted cash flow model deserves a place in your investing arsenal.
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