When taking a long-term fundamentals approach to investing, decisions should be based on the intrinsic value of a company. That means valuing companies based upon their ability to generate cash.
The best metric for company growth is, as discussed in the past few articles, enterprise value. In this case, however, we will be deriving enterprise value through discounted cash flow, or DCF. This process involves discounting projected free cash flow from the operating model to derive the value of that future money at the current time.
Discounting is actually a fairly intuitive process. It is as a result of the time value of money principle, which says that money available at the current time is worth more than the same amount of money at a later time. Think about it. You would rather be given ten dollars right now than ten dollars a year from now, thus ten dollars a year from now is worth less to you. Let’s illustrate how this works in real life with an example:
You are saving up to buy a puppy one year from now which you find out will cost you $1,000. With current savings account rates at 5% (we can dream), you wish to determine how much money you need to have in your account today, to end up with the desired amount one year from now. Here is the calculation you would do to get that value: 1000 ÷ 1.05
This should get you a current value of $952.38.
In this example, the future value is $1000, the discount rate is 5%, the # of periods is 1 and the present value is $952.38.
If instead, you allocated yourself three years to save up $1,000, then you would calculate the following: 1000 ÷ 1.053
This should get you a current value of $863.84. The # of periods has now changed to 4, and your present value to $863.84, accordingly.
The formal definition of discounted cash flow is as follows, where CFₜ is the cash flow in period t, r is the discount rate, and t is the life of the asset that is valued.
When all projected periods are combined, it should look something like this:
Now that you understand the concept of DCF, the next logical question would be how we find the discount rate for cash flows. Many sources may use a methodology involving something called WACC, or the weighted average cost of capital, though we will be following in the footsteps of the asset management firm Turtle Creek, using a flat 10% discount rate per annum. The reason for this is that we subscribe to the notion that it is important to apply a consistent rate, and that there is much empirical evidence backing a discount rate in the range of 10% over the long-term. The intrinsic value of a good company should not be affected by interest rates, as it would if you were using WACC. A detailed explanation for this is beyond the scope of the piece, but feel free to go to this link for an elegant justification.
You can forecast future cash flows with a revenue build along with capital expenditures(capex) and net working capital(NWC) assumptions, or use an operating model which you can learn to build here. Be sure to have high conviction in your model assumptions as that is what the entire process is based upon. Your model is just like a mathematical equation, and every single one of your inputs needs to be thoroughly researched or else your outputs are essentially useless. In a professional setting, you may want to extrapolate and use cash flows for 10 or 15 years, but 5 years will suffice for our purposes. Now that we have all the necessary information, we shall input all of the values into our formula and calculate the present value.
You may be wondering: If we only accounted for 5 years worth of cash flows, then does that mean that all cash flows beyond that period are left not included? Well, no. That’s where the terminal value comes into play. With the terminal value, we essentially estimate a lump-sum of money we forecast the company will generate for its remaining life beyond the horizon of our predictions (not including the 5 years we have accounted for) and then discount it back all together. There are two methods of arriving at terminal value, and we’ll be going into both of them.
1. Perpetual Growth
With the perpetual growth method, we project a normalized growth rate for the company into perpetuity (forever). The terminal value formula for this method is shown below, where FCFn is the free cash flow of the terminal year (last period for which we forecasted), r is the discount rate (recommend flat 10% rate), and g is the growth rate. For the growth rate, make sure to use a value of 2% or less. Otherwise, your company would be outpacing the growth of the entire economy it’s within, and at some point be forecasted to become larger than the economy itself. Before entering a value, you might want to try plugging in a growth rate of 0% just to see what happens and to make sure the rest of your inputs make sense.
2. Exit Multiple
With the exit multiple method, we arrive at the terminal value by multiplying the EBITDA of the terminal year by the average EV/EBITDA ratio of the company’s peer group. You can learn more about finding the peer group and multiple yourself in our article on comparable company analysis.
Both the perpetuity growth method, as well as the exit multiple method, have their flaws. Perpetuity growth goes off the assumption that the company will live-on forever when this has never and will never be the case. The exit multiple assumes that the EV/EBITDA multiple will consistently remain the same for the industry moving forward when this is often highly unlikely. Some investors are diehard fans of one method over the other, but if you’d like a good balance, you may decide to calculate both and take the average.
Now that you have both the terminal value as well as the present value, you can take the sum of both of these to get your enterprise value. Subtracting the company’s total debt and adding cash + cash equivalents will get you the company’s market capitalization, which can be divided by the number of shares outstanding to get the price per share.
Once you are done all of this, you can go back and tweak your model by adjusting discount and growth rates. Your goal should be to get your entire model to imply today’s share price, and then see where your assumptions differ from the market. The “sensitivity table” function in Excel can help you see what happens to the share price of the company with varied combinations of growth rates and discount rates. With a completed model, you can compare your target share price to the current share price to determine whether the company it’s a good buy.