Discounted Cash Flow, a feature on GuruFocus’ new Valuations Tab, is a more encompassing method of valuing businesses than isolated ratios because it takes into account book value, current free cash flow, business growth rate and terminal value. The model arrives at an intrinsic value of a business that includes balance sheet value, future business earnings and earnings growth.
Calculating the entire value of the business in this way gives a number that is comparable to the stock price. For instance, if a company has a DCF value of $10 and the stock is trading for $15, the stock is undervalued.
Warren Buffett commented on the DCF valuation model in his 1992 Berkshire Hathaway (BRK.A)(BRK.B) annual letter: "In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."
The formula for finding the DCF of a company is rather complex:
Intrinsic Value = Future Earnings at Growth Stage + Terminal Value
= E(0) x(1-xn)/(1-x) + E(0)xn y/(1-y)
where x=(1+g)/(1+d), and y=(1+t)/(1+d)
E(0) – current earnings
g – growth rate
d – discount rate
t – growth rate at terminal state
n – number of years at the growth rate of g
If the growth rate is equal to the terminal rate, which means that the company is growing at a constant rate forever (x=y in the above equation) the equation becomes:
Intrinsic Value = E(0) x(1-xn)/(1-x) + E(0)xn x(1-x)
= E(0) x/(1-x)
GuruFocus’ new Valuations Tab under each guru’s Current Portfolio Tab automatically calculates the DCF intrinsic value of their stock holdings.
David Einhorn is a well-known value investor famous for, among other things, his ability to identify undervalued or overvalued companies and taking corresponding long or short positions in them. For instance, he bought Apple Inc. (AAPL) in the first quarter of 2010 at an average price of $255 per share, making a 140% gain on the stock that has increased to $610 on Thursday.
Einhorn, of course, has a proprietary process for valuing stocks, but within his portfolio are a number of stocks trading below their intrinsic value based on the DCF model. Here are the top 10:
|Legg Mason (NYSE:LM)||$78.70||$26.56|
|Computer Sciences Corp. (NYSE:CSC)||$69.22||$25.09|
|DST Systems (NYSE:DST)||$66.55||$55.84|
|Best Buy (NYSE:BBY)||$54.03||$21.77|
|Tessera Technologies (TSRA)||$25.65||$15.50|
|Marvell Technology (NASDAQ:MRVL)||$16.09||$11.01|
|Aspen Insurance Holdings (NYSE:AHL)||$116.48||$29.44|
See more valuations of Watsa’s stocks here.
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