“An investment in knowledge always pays the best interest.” –Benjamin Franklin
So you want to make money investing. How do you do that? Buy Low and Sell High (going Long); or Sell High and Buy Low (short selling). In order to achieve these goals you need to properly value the company’s worth-its intrinsic value. If you learn how to build a great Discounted Cash Flow (DCF) Model, you can increase the odds of growing the value of your investment portfolio. You will also add this valuable tool to your investment knowledge.
Investopedia defines Discounted Cash Flow (DCF) as follows: “A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.”
There are two ways to develop a DCF Model. The first approach is thru calculating the Free Cash Flow to the Firm (FCFF):
FCFF = Cash Flow from Operating Activities (CFO) + Interest Expense (1 – Tax Rate) – Capital Expenditures
WACC = Weighted Average Cost of Capital
Firm Value = FCFF1 / (1 + WACC) ^ 1 + FCFF2 / (1 + WACC) ^ 2 + … + FCFFn / (1 + WACC) ^ n + …
Equity Value = Firm Value – Market Value of Debt
The second method is thru calculating Free Cash Flow to Equity (FCFE):
FCFE = CFO – Capital Expenditure + Net Borrowing from Debt Holders
r = required rate of return = the required Discount Rate
Equity Value = FCFE1 / (1 + r) ^ 1 + FCFE2 / (1 + r) ^ 2 + … + FCFEn / (1 + r) ^ n + …
Step 1) Determine Forecast Period
The forecast period is the time period that you are projecting yearly cash flows to input into the DCF Model. Cash flows after the forecast period can be represented by a fixed number or your estimation for Continuing Value. As a rule of thumb, your forecast period should be around 5 to 10 years because it is harder to accurately project further into the future.
Step 2) Determine Yearly Cash Flow
For FCFF DCF Model, estimate CFO, Interest Expense, Tax Rate, and Capital Expenditure for each year of the forecast period.
For alternative FCFE DCF Model, estimate CFO, Capital Expenditures, and Net Borrowing from Debt Holders for each year of the forecast period.
Step 3) Determine WACC or Discount Rate
For FCFF DCF Model, determine the appropriate WACC for the model.
For alternative FCFE DCF Model, determine the appropriate Discount Rate for the model. A good primer on Discount Rates can be found in the following article entitle “How to Improve Your Bottom Line by Correctly Determining Discount Rates”:
Step 4) Determine Current Value
Calculate the current value of future cash flows by determining the Present Value of those future cash flows.
Current Firm Value = FCFF1 / (1 + WACC) ^ 1 + FCFF2 / (1 + WACC) ^ 2 + … + FCFFn / (1 + WACC) ^ n
Current Equity Value = FCFE1 / (1 + r) ^ 1 + FCFE2 / (1 + r) ^ 2 + … + FCFEn / (1 + r) ^ n
Step 5) Determine Continuing Value or Terminal Value
You can estimate the Continuing Value or Terminal Value by the following formulas:
Terminal Value for FCFF = FCFFn * (1 + g) / (WACC – g)
g = projected growth rate
Terminal Value for FCFE = FCFEn * (1 + g) / (r – g)
You would then have to calculate the Present Value of the Terminal Value by discounting it back.
PV Terminal Value FCFF = Terminal Value for FCFF / (1 + WACC) ^ n
PV Terminal Value FCFE = Terminal Value for FCFE / (1 + r) ^ n
As an alternative, you can Estimate Terminal Value with a PE Multiple. If an analyst estimates the EPS of Company XYZ in 5 years to be $2.10 and the median trailing industry PE to be 35. The Terminal Value in Year 5 is equal to 35 * $2.10 = $73.50.
Step 6) Add Current Value and Terminal Value
For FCFF DCF Model:
Firm Value = Current Firm Value + PV Terminal Value FCFF
Equity Value = Firm Value – Market Value of Debt
For FCFE DCF Model:
Equity Value = Current Value + PV Terminal Value FCFE
A Simple 10-Year Valuation Model
In the book, “The Five Rule for Successful Stock Investing” by Pat Dorsey, the author breaks the process down into 5 steps.
- Forecast free cash flow (FCF) for the next 10 years.
- Discount these FCFs to reflect the present value.
- Discounted FCF = FCF for that year / (1 + R) ^ n
- R = discount rate
- N = year being discounted
- Calculate the perpetuity value and discount it to the present value:
- Perpetuity Value = FCF in year 10 * (1 + g) / (R – g)
- Discounted Perpetuity Value = Perpetuity Value / (1 + R) ^ 10
- Calculate total equity vale by adding the discounted perpetuity value to the sum of the 10 discounted cash flows (from Step 2):
- Total Equity Value = Discounted Perpetuity Value + 10 Discounted Cash Flows
- Calculate the per share value by dividing Total Equity Value by shares outstanding:
- Per Share Value = Total Equity Value / Shares Outstanding
To learn more about DCF Models or Free Cash Flow Models, another great book besides the one by Pat Dorsey is entitled “Strategic Value Investing” written by a number of CFAs.
You can also find a sample DCF Model I built using Pat Dorsey’s guiding principles at the following:
If you use these principles you will build a great Discounted Cash Flow (DCF) Model. As a result, you can increase the odds of growing the value of your investment portfolio because you can calculate intrinsic value better.