Investors often ask whether they should build out a DCF model for every investment. It is very time-consuming and oftentimes seems pointless for well-known companies such as Google and Amazon. However, we still recommend investors to use DCF valuation for their stock research, particularly for the less well-known companies. This is a practical step-by-step guide on how to do a DCF valuation.
Why use a DCF valuation?
Discounted Cash Flow (DCF) models are commonly favored in the finance profession.
There are two reasons that every investor should build out DCF models. One, DCF is based on financial forecasts. Forecasting helps you understand the key drivers of the business fundamentals. These include sales, gross profit, and operating profit.
Building out a model is the best way to understand the fundamental details of what the company’s business segments are, how they grow, and how they make money.
Second, having a DCF valuation gives you a rough of idea of whether a company is undervalued, fairly valued, or overvalued. Investing in high-growth companies with premium valuation such as Netflix and Tesla is fine, as long as you understand what growth assumptions are baked into their DCF valuation.
DCF valuation is about calculating firm value
The whole point of a DCF model is to calculate the “firm value” of a company. A company’s firm value is the market value of the firm’s equity plus the market value of the firm’s financial debt.
In a DCF valuation, firm value is the present value of the firm’s futures free cash flows (FCF) plus the value of its current cash on hand and marketable securities. The present value of the firm’s FCF is discounted using the weighted average cost of capital (WACC).
Often when individuals discuss the firm value, they really mean the value of its shares. It is better to use the term equity value for the value of a company’s shares and to use the term firm value to define the market value of the firm’s equity plus its debt.
Learning DCF valuation through an example
To provide an idea of firm value, we’ll use the example of Motherboard Shoes. Motherboard Shoes was listed on the Chicago Stock Exchange in 2005, but the majority of the stock is owned by the Motherboard family, which founded the company and still runs it.
The Motherboards have received an offer for their shares from
Century Shoe International. The offer is $50 per share. They would like to know if the offer is a fair one.
Let’s build a simple DCF model to value Motherboard Shoes:
Let’s go over this DCF valuation. This model projects 5 years of future FCFs and has also projected a terminal value at the end of year 5 year. The future FCFs and the terminal value are discounted using an assumed WACC of 20%.
A 20% WACC is high, though we are using it here for simplicity purposes. We’ll go over how to calculate a more realistic WACC for DCF valuation below.
Adding current balances of cash and marketable securities to the present value of the FCFs and subtracting out the value of the firm’s debts gives an equity valuation of $59,157,407 (cell B15). Since there are one million shares outstanding, this values each share at $59.16 (cell B18).
DCF valuation step 1: calculate the WACC as discount rate
The WACC is the discount rate for the future FCFs. It includes both the cost of debt plus the cost of equity:
WACC = MV of Debt/(MV of Debt+Equity)*Cost of Debt + MV of Equity/(MV of Debt+Equity)*Cost of Equity
The cost of debt is the weighted average interest rate of the debt instruments the company has employed.
The CAPM model
The cost of equity is calculated using the capital asset pricing model (CAPM). The CAPM says a company’s cost of equity equals the risk-free rate plus the product of the equity risk premium and beta.
The CAPM model is defined as:
Cost of Equity = Risk-free Rate + Beta*Market Risk Premium
Let’s start with the beta. It’s the sensitivity of a stock’s price movement relative to the broader market.
A beta of 1.0 means the stock tends to move in line with the market. A beta below 1.0 suggests a stock moves less than the market, while a beta above 1.0 implies moves greater than the market.
Use the 10-year treasury yield as the risk-free rate. Estimates for the equity risk premium and beta prove more challenging.
Most of the problems with the cost of capital come from stale inputs for beta and the equity risk premium. For example, the geometric average equity risk premium was 1.9% from 1982 – 2005, 3.7% from 1962 – 2005, and 6.2% from 1926 – 2005. Use the higher geometric average of 6.2% to be conservative.
The arithmetic average equity risk premiums during the same time frames were higher. One area of debate in DCF valuation is whether the geometric or arithmetic average is more appropriate. We favor geometric returns for long-term models and arithmetic averages for short-term return forecasts.
DCF valuation step 2: project the free cash flows
The next step is to forecast the company’s future free cash flows, based on the company’s sales growth and profitability. The formula for FCF is:
Less: (Capital Expenditures – Depreciation)
Less: Change in Working Capital
= Free Cash Flow
And how do we get from sales to EBIT, Earnings Before Interest and Taxes? While drivers of company fundamentals differ from sector to sector and from company to company, the following are the common denominators in forecasting a company’s future earnings.
Here is the common formula:
Less: Cost of sales
= Gross Profit
Less: Selling, General and Administrative Expenses
= Earnings Before Interest and Taxes (EBIT)
As you can see, the common drivers of free cash flows are sales, gross profit margin, EBIT profit margin, capital expenditures, and changes in net working capital.
These drivers are called “company fundamentals”. Let’s go over each of the drivers.
This is the most important driver of corporate value. Changes in sales have a material influence on profitability and are generally larger than those for cost savings or investment efficiencies. Changes in sales growth rates are particularly important for companies that create shareholder value and have high expectations.
To forecast sales, look at the company’s historical sales growth and industry growth. Think about whether a company can continue to outgrow the industry and its historical performance, or vice versa.
Gross margin is a measure of a company’s ability to make money. Firms with high gross margin deliver better total shareholder returns than those with low margin. For forecasting, think about whether can a company continue to improve its gross margin? Or would gross margin decline because of pricing pressure?
Investors are commonly too optimistic about earnings growth and often miss estimates by a wide margin. Operating leverage measures the change in operating profit as a function of the change in sales. Operating leverage is high when a company realizes a relatively large change in operating profit for every dollar of change in sales.
Capital expenditures (CapEx) is the money invested by a company in acquiring, maintaining, or improving fixed assets such as property, buildings, factories, equipment, and technology.
The formula for CapEx is:
CapEx = Current PP&E – Previous PP&E + Depreciation
Alternatively, a simple way to forecast capex is to calculate previous CapEx as % of sales and assume a similar level going forward.
Changes in net working capital
Net working capital is defined as current assets minus current liabilities. Therefore, a change in the total amount of current assets without a change of the same amount of current liabilities will result in a change in the amount of working capital. Similarly, a change in the total amount of current liabilities without an identical change in the total amount of current assets will cause a change in working capital.
DCF valuation step 3: project the long-term FCF growth rate and the terminal value
DCF valuation requires us to project an infinite number of future FCFs, but this is impossible. A practical solution to this problem is to define the firm’s terminal value as the firm value at the end of the forecasting year.
Terminal value is what we project the firm to be worth at the end of forecast period.
The long-term FCF growth rate
Let’s go back to our Motherboard Shoes example. The terminal value formula requires us to estimate the long-term FCF growth rate. In the financial planning model for the Motherboard Shoes FCFs, this long-term growth rate is different from the sales growth rate projected for the company’s next five years.
In the full DCF model below, we use a high sales growth rate of 10% for Motherboard over the forecasting period. Then we assume that the long-term FCF growth rate can’t grow forever at a rate greater than the economy in which it operates.
We assume that the long-term GDP growth of the U.S. economy is 5% and that this rate is also the long-term rate for Motherboard Shoes.
DCF valuation step 4: determine the firm value
At this point all the elements of the firm valuation formula are in place:
- WACC, the discount rate for the FCFs and the terminal value
- Projected FCFs
- The terminal value of the firm
- The firm’s initial (year 0) balances of cash and marketable securities
We can now value the firm:
DCF valuation step 5: value the firm’s equity
The firm value is the value of the firm’s debt + equity. We are interested in valuing only the firm’s equity – our estimate of the market value of the firm’s shares.
We then calculate the firm’s fair stock value per share. Motherboard Shoes has 1,000,000 shares outstanding, the estimated market value per share is $59,157,407/1,000,000=$59.16.
DCF valuation step 6: adding mid-year valuation
The firm’s FCF is generated throughout the year, and not just at the beginning. To be more precise, we’d want to calculate the present value of the FCFs assuming each FCF is generated in the middle of the year.
For Motherboard Shoes, mid-year valuation makes sense, since the company’s sales occur throughout the year and not just at year-end.
In the spreadsheet below you can see how mid-year valuation affects the value of the firm and projected share valuation: Cell B8 shows that the present value of future cash flows and terminal value firm value increases from $69 million to $75 million. In cell B18 you can see that the projected share value increases to $65.71.
Motherboard Shoes: the complete DCF valuation
We have now completed Motherboard Shoes’ DCF valuation. Let’s take a look at the complete model, include the mid-year valuation we performed in the last step:
DCF sensitivity analysis
There are sensitivities we can perform in the DCF model. For example, we can see how different sales growth rates would affect the DCF valuation.
For Motherboard Shoes, we estimate the sales growth to be10% annually for the next 5 years.
Let’s sensitize this using a data table. As you can see, the effect of this sales growth assumption is quite dramatic. The greater the sales growth (cell B2), the greater the valuation of Motherboard’s shares:
Common errors in DCF valuation
Here’s our list of the most frequent errors we see in DCF models. We recommend you check your models, or the models you see, versus this list.
If one or more of the errors appear, the model will do little to inform your business judgment.
Forecast horizon that is too short
The most common criticism of DCF valuation is that any forecast beyond a couple of years is suspect. It might be better off using more certain, near-term earnings forecasts.
We believe that forecasting out to 10 to 20 years is important. We forecasted Motherboard Shoes with a 5-year DCF as a simple example. However, we recommend that you use at least a 10-year forecast horizon in practice.
Imagine you are a restaurant industry executive in charge of finding new store locations. When assessing the attractiveness of a prospective site, would you consider only two years of earnings because “any beyond that is guessing”? Of course not.
You’d base your judgment on the location, past results for similar sites, and other value-relevant factors. Intelligent investors take a long-term view.
Incorrect cost of capital
Forecasting the cost of capital correctly is rarely an edge in investing. However, forecasting it incorrectly can introduce tremendous deviations from the company’s fair value.
Avoid using the cost of equity as the total cost of capital, as most company’s capital structure is comprised of both debt and equity.
Mismatch between investments and EBIT growth
Companies invest in the business by growing working capital, capital expenditures, acquisitions, R&D, etc. Return on investment (ROI) determines how efficiently a company translates its investments into earnings growth.
DCF valuation commonly underestimates the investment necessary to achieve an assumed growth rate. This mistake often comes from two sources.
First, investors looking at companies that have been acquisitive in the past extrapolate acquisition-enhanced growth while only reflecting capital spending and working capital needs for the current business.
The second reason for underestimating investment needs stems from a simple failure to link growth and investments via ROI. Investors often forecast sales and margin growth independent of investments.
A simple way to check for this error is to add an ROI line in the model. If you see ROIs rising or dropping sharply without a thoughtful strategic underpinning, the DCF model is likely unreliable. The vast majority of the DCF models we see make no effort to reflect a link between growth and investment.
If you see ROIs rising or dropping sharply without a thoughtful strategic underpinning, the DCF model is likely unreliable.
Discount to private market value
Although this mistake was mainly done during the 1980s and 1990s, we still see DCF models that calculate a DCF value and then apply a “public market discount” of 20% to 25%. Don’t do that.
Avoid double-counting of buybacks
Companies generating free cash flows often have a record of buying back stock.
Investors sometimes build buybacks into their DCF models by assuming the company uses free cash flow to shrink shares outstanding over time.
This is double-counting because the model values the cash flow and the model uses the same cash flow to reduce shares outstanding. You do not need to reduce the shares outstanding assuming stock buyback continues.
Not forecasting scenarios
The large majority of DCF models reports we see offer one scenario and investors often peg their target prices on that single scenario. Given investing is inherently probabilistic, one scenario is not thorough analysis. You would need to consider multiple scenarios.
DCF valuation – final words
That’s it for our practical, step-by-step guide on DCF valuation. Let us know if you have any questions!