Stock Valuation Models: Part 1
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 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.
In this guide, we will walk you through one of the most fundamental stock valuation models you will need to pick out the best long-term investments.
Known as the Discounted Cash Flow (DCF) analysis, almost all other valuation methods are built upon this one.
With so many potential companies out there, I expect the time you spend here will pay rich dividends!
This is Part 1 of a 2 parts series. You can find Part 2 in this link.
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 a company’s intrinsic value (value based on a company’s ability to generate cash flows) 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.
- 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
Formula for Discounted Cash Flow (DCF)
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 is simply meant to showcase the general reasoning behind the DCF stock valuation model.
Let’s break it down.
Step 1: Estimate the expected cash flows of the investment
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 2019, according to the company’s 10K statement, provides this information:
- Cash Flow From Operating Activities = $1.608 billion
- Capital Expenditures = $1.157 billion
Free Cash Flow = $1.608 billion−$1.157 billion = $450 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 2017 till now, Macy’s capital expenditures have been increasing due to its growth in stores, while its operating cash flow has been decreasing, resulting in decreasing free cash flows.
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 it comes to 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 five years.
The DCF valuation of a business is simply the sum of the discounted projected Free Cash Flow amounts (for five 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
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:
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:
Example Of Exit Multiple Calculation
- 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.
- Multiply the EV/EBITDA multiple ranges by the end of period EBITDA estimate.
Year 6 EBITDA = $13,367
EV/EBITDA Multiple Range = 6.0x
Terminal Value = $13,367 × [6.0x] = $80,203
PART 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.
Part 2 of this guide will delve into the final two steps in the DCF analysis, with more examples to guide you along. Finally, you will also be introduced to a simpler version of stock valuation, the Dividend Discount Method or DDM for short, using the same principles covered in DCF.
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