Performing a discounted cashflow or DCF valuation is the underlying method or tool for stock valuatins according to the notion that a company is worth the present value of future cashflows.
DCF valuations include some crucial steps. The first step is to choose the cash flow stream you want to discount and the according discount rate. You can value the entire firm called (1) entity approach or you can value the (2) equity capital only.
- Free Cash Flow to the Firm (FCFF) and WACC or
- Free Cash Flow to Equity (FCFE) and the required rate of return on equity.
We will use FCFF and WACC in the following which gives us the present value of the firm, called enterprise value or EV.
Enterprise value or EV is the present value of all future free cashflow to the firm (FCFF). Most valuations make use of a two phase model. The sum of the discounted cashflows within the detailed period results in the first building block. Assuming the company reaches its steady state after the detailed period, the present value of cashflows after the detailed period (the terminal value) are calculated making use of a formula. The discount rate or WACC and a terminal growth rate (tgr) are used as inputs for this formula. It is usually assumed that the company growth its earnings (or cashflows) into perpetuity.
Pls read The time value of money for understanding the algebra used when discounting cashflows. I promise, it’s not that hard 😉
Subtracting Net Debt (or adding net cash) from EV results in total equity value (TEQ). Since debt investors have a claim on the companys earnings, this step is needed to get to the equity value. Other claims on equity lower the value for common shareholders (FEQ) and have to be taken into account. Such other claims can be options granted to employees in the past, differences in voting rights, or hybrid bonds.
Fair equity value over (the adjusted) number of oustanding shares (read more here) leads to our estimate of fair value per share.
If valueing an ADR instead of a commen stock it is necessary to account for the ratio of shares per ADR. Likewise, incorporating current foreign exchange rates gives us fair values in other currencies.
A margin of safety should be applied to the fair value. As value investors we want to buy securities below (or at a discount to) their fair value. Depending on the risk or quality of the company the required discount to fair value can be higher or lower. If the current price per share is below our buy price, resulting from discounting the fair value, we might want to buy the security after comparing the proposition with available alternative opportunities.
Performing sensitivity anlaysis with regard to the question how does our estimated fair value change if we change critical valuation imputs provides important information. Since we can never be certain about our assumptions (i.e. wacc and tgr) we want to be sure that our estimated fair value is rather stable with regard to key inputs. Changing these inputs will give us a range of fair value estimates (and might affect our conviction). We prefer a narrow range to a wider range of possible outcomes and obviously we want to have a high probability to buy at a reasonable discount to true underlying value.
To decide on what discount rate to use, is a question for another day …
The below illustrates the steps included in a DCF valuation. I used this map for building my valuation model.
Many market participants (some of them investors) shun DCFs for various reasons. I agree very much with Mauboussin’s observation:
The value of a financial asset is the present value of future cash flows. Few serious market practitioners would disagree. But many investors shun models that project and discount future cash flows because they deem them too complicated or sensitive to assumptions. Yet these same individuals seem blithely content to rely on multiples.Mauboussin, What Does a Price-Earnings Multiple Mean?
Here’s the challenge. With discounted cash flow models, the value is sensitive to the inputs. But the assumptions underlying the inputs are explicit. You can compare them to base rates, discuss them, and debate them. With multiples, those assumptions are buried. The assigned multiple becomes a point of persuasion rather than a thoughtful case based on the economic drivers of value. – Mauboussin
Usual problems with the NPV are (i) future cashflows are quite uncertain and (ii) the choice of discount rate can be arbitrary. In general, far more things can go wrong than things that can go right.
Even buying good businesses is not always a good buying decision, since:
For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.Margin of Safety by Seth A. Klarman (1991)
There is only one answer to all these (and more) risks and uncertainties: conservatism.
There is no single correct discount rate (sorrry it’s not always 10%). Things to be considered when approximating a realistic and conservative discount rate is (i) the personal preference for present over future consumption (cash flows), (ii) the investor’s risk profile and (iii) returns for alternative investments. Regarding low interest environments (as nowadays), Klarman writes:
At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available.Margin of Safety by Seth Klarman (1991)
In conclusion, business valuation is a complex process yielding imprecise and uncertain results. Indeed, many businesses are so complex or difficult to understand that they simply cannot be valued. Investors must remember they do not need to swing at every pitch to do well over time! And it is woth to remember: Shortcuts using conventional valuation yardsticks is usually not enough.
- Mauboussin: Common Errors in DCF Models