Valuation Using Discounted Cash Flow

Friday, September 8, 2006

Motley Fool Staff, The Motley Fool, http://www.fool.com/m.asp?i=2117802&u=205134671

Valuing a company on your own might seem intimidating. Companies
are large, complex entities, and each seems to have its own
nuance. So how are you supposed to look at all of the operations
of a company and determine what it is worth?

One of the preferred methods we use at Motley Fool Inside Value
is to figure out how much cash will come our way in the future,
and then put a price tag on it today.

WHY BOTHER?
All investors should care about valuation -- even those
investing in exciting growth stocks. Even if you believe that a
genius design in consumer electronics will ensure the company's
success, that doesn't mean that shareholders will profit from
that success. For example, suppose that a company's stock was
trading at a level equivalent to the worldwide gross domestic
product. Clearly, anyone buying shares at those levels would be
almost certain to lose money, regardless of how great a company
it is.

Most companies are obviously nowhere near such prices, but the
example shows that, regardless of what you think about the
prospects of a company, there exists a price at which that
company is too expensive. To determine whether a stock is an
attractive investment, you must be able to calculate the value
of that company.

HOW TO CALCULATE VALUE
One way of valuing companies is based on their assets, a method
of valuation that is particularly appropriate for real estate
investment trusts (REITs), which earn revenue roughly
proportional to their assets. For instance, some REITs own
office buildings that they rent to tenants. These companies can
be valued using their net asset values (NAV) by calculating how
much money they'd have if they sold all their buildings and paid
off all their debt. Determining the true worth of a particular
building is a challenge, so, while this method is easy to
understand, it's not practical for the average investor.

Another way of valuing companies that pay regular dividends is
using the dividend discount model. This model is based on the
idea that a stock is worth the money that it will distribute to
shareholders. In other words, the value of a company is the sum
of the present value of future dividends.

A third way of valuing a company, usable by any investor, is the
discounted cash flow (DCF) model. This model assumes that the
value of a company is the sum of the present value of all the
cash that the company will make in the future. We use this model
extensively at Inside Value to identify undervalued companies
that are likely to provide investors with exceptionally high
returns.
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DISCOUNTED CASH FLOW
Probably the trickiest part of the DCF model is the concept of
discounted value or present value. This concept becomes clearer
when you consider how the value of money changes over time.

Suppose that we're willing to give you $20 either today or in 10
years. Most likely, you'd choose to have the money today. After
all, there will likely be inflation over the next decade, so
you'll be able to buy more hamburgers with that $20 now than
you'd be able to buy in 10 years. Or perhaps you like money more
than you like hamburgers, so you decide to invest that $20 in
bonds earning 5% annual interest. In 10 years, that $20 will
have grown to $32.58. Thus, $20 now is worth 63% more than $20
in 10 years.

Now turn the question around. What is the present value of $20
in 10 years? In other words, how much money would we have to
leave in 5% bonds to have $20 at the end of 10 years? The answer
is $12.28 ($20 divided by 1.05 to the power of 10). Ten years in
the future, you could consider an IOU for $20 as worth only
about $12 today, because the discounted value of $20 is $12. In
this case, 5% would be the discount rate.

The DCF model uses this method to calculate a company's value by
discounting to present value the money that the company will
make in the future. For instance, suppose that Inside Value
recommendation Coca-Cola (NYSE: KO) will earn $1,000 every year
for the next 30 years. You could calculate the value of that
company, using a 5% discount rate, as follows:
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http://www.fool.com/m.asp?i=2117805&u=205134671


Year Cash Flow Discount Discounted Value
1 $1,000 1.0000 $1,000.00
2 $1,000 1.0500 $952.38
3 $1,000 1.1025 $907.03
4 $1,000 1.1576 $863.87
29 $1,000 4.1161 $242.95
30 $1,000 4.3219 $231.38
Total $16,141.07

If the company had 1,000 shares outstanding, the value of a
share would be about $16.

THE FINE PRINT
If you play around with a DCF model, you'll find that the
company's value can change dramatically depending on the inputs.
This is normal and acceptable. As Warren Buffett has said, "It's
better to be approximately right than precisely wrong."
Regardless, it's worthwhile discussing the inputs to the model.

The core of the calculation is an estimation of the cash that
the company is likely to produce in the future. To calculate
free cash flow (FCF), use the cash flow statement in an annual
report and subtract capital expenditures from the operating cash
flow. FCF includes ongoing revenue and expenses, but not
one-time benefits such as cash received from selling a division
of the company. Free cash flow also does not include cash
received from financings, since money received from selling
bonds is not cash that the company earned.
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http://www.fool.com/m.asp?i=2117807&u=205134671

If the most recent year has unusually high or low free cash
flow, you can use an average of several years, or just a
reasonable estimate. This could be justified if, for instance,
the most recent year had unusually large capital expenditures.
When doing these calculations, remember that we're making an
estimate, and that precision has little value. We just want to
be roughly right, so don't stress out over trivial details.

Of course, cash flows do not remain constant but often grow over
time. We typically assume that the company will grow at a
particular rate for the next 10 years and then continue to grow
at the rate of inflation. After all, it's difficult to estimate
what cash flow will be 10 years in the future, and as a company
gets bigger, it becomes increasingly difficult to grow. A simple
way of estimating growth rates is to start with analysts'
estimates and discount them by 10% to 20%, since analysts tend
to be unrealistically optimistic. If analysts think a company
will grow by 15%, I'd use 13%. Be wary of estimated growth rates
of more than 25% -- companies have a difficult time sustaining
such levels.

The discount rate should reflect inflation, your confidence in
the sustainability of the company's growth, and the price of
no-risk investments. The riskier the business, the higher the
discount rate should be. We can usually use discount rates
between 9% and 16%, with most companies falling near the high
end of the range.

A BETTER WAY
To quickly perform these calculations, you can create a
spreadsheet on which you can easily specify the inputs for any
stock. At Inside Value, we spend a lot of time discussing which
stocks are overvalued and which are dirt cheap. We created a DCF
calculator that anyone can use to estimate how much a stock is
worth.

Subscribers can access the DCF calculator here.
Non-subscribers can try it out by taking a 30-day free trial.
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http://www.fool.com/m.asp?i=2117809&u=205134671

Shruti Basavaraj, Adrian Rush, and Katrina Chan updated this
article, which was originally written by Richard Gibbons. None
of the contributors own shares in any of the companies mentioned
above.

The Motley Fool has a full disclosure policy.
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