This is the intrinsic value calculated from the Discounted Earnings model with default parameters. The calculation method is the same as Discounted Cash Flow model except earnings are used in the calculation instead of free cash flow. This is the default method of calculation with GuruFocus DCF calculator.
Usually a two-stage model is used in calculating the intrinsic value with discounted cash flow model. The first stage is called growth stage; the second is called the terminal stage. In the growth stage the company grows at a faster rate. Because it cannot grow at that rate forever, a lower rate is used for the terminal stage.
GuruFocus DCF calculator is a two-stage model. The default values are defined as:
1. Discount rate: 12%
2. Growth Rate in the growth stage = average earnings growth rate in the past 10 years or 20%, whichever is less
3. Growth stage lasts 10 years
4. Terminal growth rate = 4%
5. The terminal stage last 10 years
6. The earnings per share is used as the default. The reason we are doing this is we found that historically stock prices are more correlated with earnings than free cash flow.
7. All of the default settings can be changed.
Unlike valuation method such as Net Current Asset Value, Tangible Book Value per Share, Graham Number, Median Ratio etc, the discounted Cash Flow model evaluates the companies based on their future earnings power instead of the value of their assets.
What you need to know about Discounted Earnings model:
1. The Discounted Earnings model evaluates a company based on its future earnings power
2. Growth is taken into account; therefore a faster growth company is worth more if everything else is the same.
3. Since we are projecting future growth, it is assumed that the company will grow at the same rate as it did during the past 10 years. Therefore this model works better for the companies that are relatively consistent performers .
4. The DCF model works poorly for inconsistent performers like cyclicals.
5. Your expected return from the investment is a reasonable discount rate assumption.
6. A larger margin of safety should be required for companies with less predictable businesses.
You can screen for stocks that trade below their intrinsic value (DCF) and Intrinsic Value (Discounted Earnings) with the GuruFocus All-in-One Screener. Companies with a high Predictability Rank that trade at a discount to their Intrinsic Value (DCF) and Intrinsic Value (Discounted Earnings) can be found in the screen of Undervalued Predictable Companies.
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