Company valuation using discounted cash flow
Discounted Cash Flow analysis explained and demonstrated
Snir's investing desk is a newsletter focused on intelligent, value investing for the individual investor. The subjects are evergreen and deals with the essence of investing, mental models, and concepts.
Valuing a company is an essential step in every investment. Skipping the valuation step can harm your long term returns significantly.
Even if the company is great, their growth is healthy, the management is competent, and the moat is strong - buying a company at the wrong price can be detrimental.
Such would be the story of Microsoft if you invested in the two years of 1998 and 1999. The company would have turned 0% for you in 15 years.
But it's not that the company was underperforming - on the contrary. In 1999 Microsoft's net income was 3.4B$, and by 2015 it was 12.1B$. That's a massive 3.55X on net income! Not revenues, but net income.
But it took 15 years for the stock to get to the price of 1998-1999 simply because it was overvalued back then. It was a great company, and the growth proves as much - but the price wasn't right.
In this article, I will explain how to utilize DCF analysis for valuing a company. In the end, we'll run a basic DCF analysis on Microsoft of 1998 and see what that analysis would have told us back then.
First, I want to let you know I built a DCF analysis tool that is available to you and make it easy to perform the analysis online and share it with others.
What is DCF
DCF stands for discounted cash flow. It is a way to get a present value of future cash flows.
You can use DCF analysis with any asset generating money. It can be a company, real estate, or even a new software service for a business that promises unrealized business returns.
It is not suitable for every valuation task, though. As you'll see, it depends on some variables that are sometimes unavailable reliably for some assets.
For example, as you need to estimate future cash flows, high growth companies usually don't fit in as the margin of error in future growth estimates is high.
We also rely on estimating returns for the investor, usually by using Free Cash Flows. If the business has no reliable way to measure it, we can't use it too. Amazon, for example, is one such company. They keep reinvesting their incomes and focusing on growth in a way that we can't reliably estimate what their Free Cash Flows are.
Time value of money
DCF analysis has the time value of money concept in its base. It recognizes money has a lower value as time passes - 100$ today worth more than the same 100$ a year from now.
The time value of money is related to money subjects - inflation (the money might buy less in a year), opportunity cost (having the money today enables me to generate more money from it now), and more.
We realize the present value of future money by putting a discount rate on future incomes. The discount rate is up to everyone personally - the higher the discount, the lower the present value will be. Promising you the discount amount of returns given the future incomes (or cash flows) are as predicted.
Enough talks, here is the formula for discounted cash flow:
- CF - Cash Flow, the expected cash flow from the asset at each period. CF1 is for the first year, CF2 is for the second year, and so on.
- r - The discount rate. How much less the money worth for you with each passing period. We will use it also as the "required return" for an investment.
- n - Time period
Simple enough. You take the incoming future cash flows from an asset and discount them to a selected rate to get the value of these future cash flows in the present.
When dealing with stock, we also want to add into the formula one terminal value. What is the asset's value at the end of the periods we are checking - be it five years, ten years, or any other period.
We do this because companies are not vanishing after the period of analysis we are making. They keep generating money into the future.
It's just that after a certain point making assumptions on the generated cash flows is futile - so we plug in a terminal value accounting for all future cash flows.
There are 2 ways to calculate the terminal value:
- Perpetual growth
- Exit multiple
Perpetual growth terminal value
After a certain point, you assume the company will grow at a stable, low rate perpetually. This formula considers the perpetual growth of the cash flows into the future with respect to the required rate of return.
- FCF - The last cash flow expected before the terminal value.
- g - The perpetual growth rate.
- r - The discount rate, as it was above, in the DCF formula.
Exit multiple terminal value
Assuming perpetual growth is great for established companies unlikely to get new "sparks". Think Coca-Cola, Exxon Mobil.
For other companies, it's better to calculate the terminal value by a probable selling multiple of the company in the future.
Usually, it is used with the EV/EBITDA multiple (and accordingly, using the EBITDA expectations). In this technique, you forecast the EBITDA of a company in the terminal period and multiply it by the expected multiple.
On choosing the "r" (discount rate)
On all formulas, you need to plug in variable "r" for the discount rate. The discount rate you'll choose will have a profound impact on the value output.
There is a systematic way to choose the "right" discount rate for a company called the WACC - weighted average cost of capital. But I will not cover it here.
WACC is for getting a "precise" valuation according to academic terms, which is fine for accountants but does not matter for us. Valuation is an imprecise act in and of itself. You make estimated future growth derived from a story you create for a company.
The output number will be imprecise no matter what and should be a tool for you to determine whether investing in some company is a good idea or not.
You'll know that a company is expensive if the price is 500$ per share where your analysis yields 100$.
"The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure" - Warren Buffett— Snir David (long term investing) (@snird) January 2, 2021
Don't over stress the accuracy of your intrinsic value calculation. It's an estimate anyway.
Required return rate
I use the discount rate as the required return rate from an investment. If I want to achieve 15% return, that will be my "r". Well, actually more than that when practically accounting for the margin of safety on top of that, but this is the general guideline.
It is not 100% accurate as theoretically, an asset price will not go to its 0% return ever, but to the risk-free rate, usually the 10 year US bond yield.
But both the theory is wrong (the market is not rational), and the process itself is never accurate. Just don't overstress this.
Risk-free rate and intrinsic value
The risk-free rate is the return rate you can get "for free" without any risk. Usually, it is the 10 years US bond yield.
Theoretically, as mentioned, an asset's intrinsic value is the discounted cash flow analysis with the risk-free rate in. It's always useful to have the intrinsic value alongside your purchase price in an analysis.
DCF in practice - Microsoft 1998
As promised, let's try to analyze Microsoft in 1998 to see what the DCF analysis would yield.
Microsoft had $7.5B of free cash flow in 1998. I used an optimistic growth estimate from that period for the future growth of the free cash flow as is. The optimistic forecast from 1998 expected a perfect run. It didn't foresee an event like the dot-com bubble burst or the 2008 financial crisis coming.
And it's good, let's see what the most naive, optimistic forecast would have told us. Mind you - this is an optimistic forecast within a bubble, so regardless, we expect the analysis to price the asset below what it was priced back then.
These growth figures expect $26.7B in free cash flow by 2008. A far cry from the real figure it turned out to be - $18.4B. But a missed forecast is not our issue here - rather, having the DCF analysis telling us the asset is overpriced within this bubble, even with an over-optimistic forecast.
Next, we want to determine the terminal value. I will use the exit multiple terminal value here with the EV/EBITDA measure.
For most of its history, Microsoft and other tech companies at that time traded at an average multiple of 10-18. That is if we ignored 1997 and 1998 when the craziness began, and it was safe to assume these multiples would not last.
I usually like to use 2 scenarios, one for "good times" and one for "bad times". The "good times" would have been a multiple of 16. But the more important one is the "bad times" - and for that, we'll use the lower end of multiples, 10.
Next, let's find the forecasted EBITDA using our growth table - using the initial EBITDA in 1998 of $7.7B.
We get a terminal EBITDA of $29.8B. In reality, by 2008 Microsoft got to $26B in EBITDA.
Next, we'll take this EBITDA value into the terminal value calculation and get the intrinsic value/purchase price. You can change the discount rate and risk-free rate above to see it take effect here.
When we require the market rate of return of 8%, the results are such that with a reasonable multiple for the terminal value and way over-optimistic growth expectations: we get a purchase price of $250B.
Microsoft enterprise value was around $250B in 1998. So is it an actual buy?
Well, not really. In reality, the discount rate for the expected rate of return should be higher than the market returns (otherwise, we'll invest in S&P 500).
And on top of that, we want to add an extra margin of safety. You know, in case a dot-com bubble or a financial crisis will come through.
To accommodate for that, let's say we choose a discount rate of 15%. On that, we take 50% margin of safety - making the discount rate 22%. With these parameters, the purchase price goes down to ~$100B. Scroll up and try it for yourself.