Discounted Cash Flow Analysis & Reverse Discounted Cash Flow
Discounted Cash Flow (DCF) Analysis
- Note: Do make sure you understand the concept of Time Value Money before working on DCF valuation.
- The main idea:- A stock's worth is equal to the present value of all its estimated future cash flow
- DCF can help us to estimate the intrinsic value for a stock (the absolute value of any company should be).
- It is complex and need to estimate all kinds of variables - growth prospects, profit margin expand/contract, how risk is the company
- Growth Rate :-
- Most important estimations - sales growth + profit margin.
- moat - company with moat can growth faster
- industry trend & economic data
- company's customer - e.g. auto part supplier vs car manufacture
- Cost
- mateirals price - e.g. oil\natural gas go up \ down? company able to pass the cost increase to their customers?
- company benefits from operating leverage? - company growth larger and spread its fixed costs across a broader base of production. --> profit rate shall growth faster than revenue. e.g. internet portal (ebay) or software company
- It doesn't have to accurate - just be reasonable & use common sense.
- We should be convervatise and emphasis on the present data rather what will happen in the future. Buffett said "In the business world, the rearview mirror is always clearer than the windshield.". We can't rely on analyst growth rates for one year estimate.
- Jae Jun (oldschoolvalue) suggested that the growth rate can be estimated based on the CAGR over multiple short term periods and then calculate the median of all those values.
- The company will go through several distinct phases, starting with a "growth" phase where earnings are increasing at a predictable rate, followed by a "mature" phase where earnings level off to a constant level.
- Based on Professor Damodaran, the alternative way of incorporating growth into value is to make it endogenous, i.e., to make it a function of how much a firm reinvests for future growth and the quality of its reinvestment.
- Growth = Reinvesment Rate * Return on Capital
- Reinvement Rate = CAPEX - Depreciation + Change in Non Cash WC
- Return on Capital = EBIT (1-t)/ Capital Invested
- Discount which cash flow?
- Old days - dividend discount model - present value of all future dividends.But, today many compaines pay no dividend. Or the actual dividends may be much lower than the potential dividends because i) managers are conservative and like to hold on to cash to meet unforeseen future contingencies and investment opportunities.
- !!! When actual dividends are less than potential dividends, using a model that focuses only on dividends will understate the true value of the equity in a firm.
- Reported earnings with non cash charge excluded (see owner earning by Warren Buffett) and it fail to take into account the need for a firm to invest in new assets in order to grow.
- Free Cash Flow = Operating Cash Flow - CAPEX --> left over cash after spending necessary money to keep it growing at its current rate.
- it is important to estimate the reinvestment rate - e.g. purchase machine to start new producton line, opening new store to expand their reach
- !!! Be sure to consider taking the median or average for the past few years to determine the normalized free cash flow. The point of the stock valuation is to be realistic, not pessimistic or optimistic.
- Two types of DCF models - should dive you a rougly same result.
- Free Cash Flow to the Firm (FCFF) - cash available to bond holders and equity holders after all expense and investments have taken place:-
- FCFF = EBIT * (1 - tax rate) - (CAPEX - depreciation) - Change in WC
- Free Cash Flow to the Equity (FCFE) - cash availalbe to equity holders after all expenses, reinvestment, and debt repayment
- FCFE = Net Income - (CAPEX - Depreciation) - Change in non-cash WC - (Principal Repayment - New Debt Issues), or
- FCFE = Operating Cash Flow - CAPEX + Net Borrowing
- Use FCFE if we are looking to value the equity - it will change if the capital structure changes. FCFE will go up if the company replaces debt with equity (an action that
reduces interest paid and therefore increases CFO) and vice versa
- FCFF is preferred if the company is unstable or has huge amount of debt because the FCFE might be very low or negative in this case.
- kcchongnz: I tend to follow Buffett's owners' earnings, ie I don't add net borrowing to boast FCFE.
- Discounting and Discount Rate
- Present Value of Cash Flow in Year N = CF at Year N / (1 + R)^N
- Zero Growth Rate - CF/R
- Constant Growth Rate - CF on Next Year/(R-g)
- R = Cost of Capital
- Stable & predictable company = low cost of capital
- Risky & unpreducatable cash flow = higher cost of capital
- Cash flow to the firm use Weighthed Average Cost of Capital (WACC) = (Weight of Debt)(Cost of Debt) + (Weight of Equity)(Cost of Equity)
- Free Cash Flow to Equity = just use cost of equity
- Cost of Equity = Risk Free Rate + Equity Premium
- calculated by CAPM but it doesn't work well as stock volatility doesn't related to fundamental factor
- fundamental risk premium - how cyclical its business is, how big it is, how much cash flow it generates, the strength of its balance sheet, and its economic moat.
- Perpetuity Value
- It's not feasible to project a company's future cash flows out to infinity - we have to stop at some point even if we believe the company will continue generating profits for a long time.
- We can estimate the company future cash flow for 5 or 10 years and then estimating the value of all cash flow in one lump sum - and we call it as "Perpetuity Value"
- Perpetuity Value = ( CFn x (1+ g) ) / (R - g) @ the last year & we need to bring it back to year 0.
- Non Operating Asset
- Asset that generate Cash Flow to the company is operating asset, e.g. Buildings, Equipment, Computers, etc.
- There are assets that do not generate any cash flow e.g. company may own some investment, properties, etc... and these assets has value.
- !!! Determining the value of non-operating assets is time intensive. Consider looking for this information once you find a company worth digging into and not right away.
- Final Intrinsic Value
- Intrinsic Value = PV for Cash flow + Cash & Cash Equivalent + Non Operating Asset + Intangible Asset - Debt - Intrinsic Value attributable to Minority Interest
- Margin of Safety = (Intrinsic Value - Stock Price)/ Intrinsic Value
- Weaknesses
- The model only work if you have realistic estimates on future cash flows, risk involved and industry analysis.
- The outcome is only as good as the data you enter. [1] Project Future Cash Flow [2] Determine a proper Discount Rate [3] Predicting Growth Rate
Reverse Discounted Cash Flow
- To eliminate the need to forecast
- To calculate what growth rate the market is applying to the current stock price - you can see whether the implied growth rate by the market is higher or lower than what the company is capable of.
- Determine discount rate, and set the growth rate until DCF intrinsic value match to the current stock price.
- It simplifies the DCF thought process and output from “what is the future growth rate?”, to “is the expected growth rate realistic?”.
You could purchase the best stock in the world, but if you buy it at a lofty premium, it is a bad investment. Vice versa, the stock could be the worst company in the world, but if bought it cheap enough, it could work out to be an excellent and profitable investment.
References:-
Reverse engineering might look like a simple solution but the problem with that approach is, its a top down approach and not bottom up approach. Bottom up DCF Models do have a much better prediction ability as its exactly visible where the cash flows should come from and also have to rely on industry experts - people familiar with the industry - rather than just guessing based on a black box
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ReplyDeleteIt's important to note that while Reverse DCF can provide insights into market expectations, it has limitations. Market prices are influenced by various factors, including investor sentiment, market conditions, and short-term trends, which may not always reflect the fundamental value of an investment. Therefore, Reverse DCF should be used as a supplementary tool and not the sole basis for investment decisions.
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