The GuruFocus site gathers together a wide variety of information and calculations that investors can use to help determine whether or not investing in a specific stock is the right choice for them.
Among these is the GuruFocus discounted cash flow calculator. The purpose of a DCF analysis is to estimate how much money can be made from an investment based on its expected future cash flows, adjusted for the time value of money (as each dollar is worth more now than it will be in the future). There are three basic estimates involved with this valuation model: future cash flows, the ending value of the investment and an appropriate discount rate.
The basic formula for discounted cash flow is as follows:
“DCF = (CF1/(1+r)) + (CF2/(1+r)) + (CFn/(1+r)),” in which CF1 is the cash flow for year one, CF2 is the cash flow for year two, CFn is the cash flow for each additional year in the calculation and r is the discount rate.
Building off of this basic formula, there are many variations used to calculate DCF. After all, it’s a popular model based on a lot of assumptions. Many businesses, investing firms and individual investors will build off the framework to form their own specialized DCF models that are more suitable for their goals.
The GuruFocus DCF calculator
The GuruFocus DCF calculator can be used to construct a DCF model based on a growth stage, a terminal stage and a discount rate. You can choose to base the DCF model on either free cash flow or earnings per share without non-recurring items.
By default, the input parameters for the DCF calculator are as follows:
- Growth rate at the growth stage: The EPS without NRI from the past 12 months.
- Years of growth at the growth stage: 10
- Growth rate at the terminal stage: 4%
- Years of growth at the terminal stage: 10
- Discount rate: GuruFocus uses the 10-Year Treasury Constant Maturity Rate as the risk free rate and rounded up to the nearest integer, then added a risk premium of 6% to get the estimated discount rate.
Based on your own research of the company and expectations of its future, you can alter the growth stage growth rate, years of the growth stage, terminal stage growth rate, years of the terminal stage and discount rate in order to arrive at your own estimation of the company’s fair value. Once you have input your desired parameters, you will see in the middle section the fair value estimate and the margin of safety estimate. If the margin of safety is positive, indicating undervaluation, it will show in green with a thumbs up symbol. If the margin of safety is negative, indicating overvaluation, it will show in red with a thumbs down symbol.
The output also contains a color scale containing five valuation zones: significantly undervalued in deep green, modestly undervalued in light green, fair valued in yellow, modestly overvalued in orange and significantly overvalued in red. Based on the margin of safety computed, the scale will point to one of the zones indicated.
The GuruFocus business predictability rank is shown above the fair value box. Using a scale of 1 to 5 stars, with 1 being the least predictable and 5 being the most predictable, the business predictability ranking measures how consistent a company has been in terms of generating returns in the past. In general, the DCF model is more reliable for companies that have a higher business predictability ranking. Further, the DCF Calculator will warn you that for unpredictable companies (business predictability rank of 1 star or less), the result may not be accurate due to the low business predictability.
To the right of the DCF calculator, there is also a “reverse DCF model.” Using the same parameters that the user has input into the DCF calculator, the reverse DCF model calculates the growth rate of earnings per share (or free cash flow, depending on which model you are using) that the company needs to achieve in the future in order to justify its current stock price. If the necessary growth rate is lower than the 10-year average annual growth rate, then it is more likely to be achievable.
If you wish, you can save your own customized settings for the DCF calculator so that you can more easily use the same parameters to evaluate other stocks. To do this, once you have set all the parameters you want for your DCF model, select the "three vertical dots” icon in the top right of the DCF calculator parameters section and choose “save parameters.”
What exactly is the discount rate?
When using a DCF model, there are many assumptions that must be made. The most difficult assumption to make is often the discount rate because costs can bring more surprises than earnings. The other components of the DCF calculator are meant to estimate future cash flows, while applying the discount rate is what gives us the present value of those future cash flows.
So what exactly is the discount rate? There is no set formula for determining this important number. A wide variety of factors impact the present value of a company’s future cash flows, including risks of failure, inflation, the cost of the capital that will be needed to produce earnings and so on. By default, GuruFocus rounds the 10-year Treasury constant maturity rate to the nearest whole number and adds a 6% risk premium.
When companies are analyzing whether or not to invest in a project, they often use the weighted average cost of capital as the discount rate. The WACC tells us how much a company is expected to pay on average to all its security holders to finance its assets. Investors only have access to the data that the company chooses to make public, so we only know the WACC for the entire company, but companies are able to assess the WACC for individual projects as well.
If inflation is expected to be high, it could also be useful to factor it into the discount rate, depending on the broader economic situation and the company’s pricing power. If commodity prices are rising faster than GDP or average wages, then inflation can have an outsized effect on companies, as they are less able to pass on costs to their customers (though this can be mitigated if the company has strong pricing power). All companies will be impacted by inflation differently, though, so this can be difficult to estimate.
Some investors might also choose to use a higher discount rate if they believe an investment to be high-risk. For example, if you believe there is a good chance a company might not live up to its growth prospects, or if there is a risk of the company failing in a significant way, you might choose to further discount future earnings out of caution.
Uses and pitfalls
For investors, the DCF model can be helpful in terms of getting an estimate of a stock’s fair value. The more research you do on the company, the more insight you might have into its ability to grow its earnings in the future. It is even more important to ensure you are applying an appropriate discount rate, as it is all too easy to become overly optimistic about a company and ignore its risks.
Since the DCF model relies entirely on assumptions, investors might want to consider changing the parameters around to several different scenarios in order to get a range of fair value estimates. This can allow for a more accurate assessment of the situation, with less chance of emotions getting in the way. One useful exercise is to set up a “worst-case” scenario, using the DCF calculator to estimate what the company would be worth if its future earnings come in at the bottom of your expectations.
Although they can be useful tools, there are a few problems to be aware of when it comes to DCF models. For one, future earnings are difficult to predict, and the longer the timeline for your estimate, the more uncertain predictions become. It is relatively easy to predict earnings for the next couple of years with some degree of accuracy, with analysts often getting within 30% or closer of the correct numbers, but beyond that, it’s often a shot in the dark. The degree of uncertainty for capital expenditures also increases the further out in the future your model goes.
Another issue is that DCF is more useful for some companies than it is for others. For example, the long-term growth prospects for cyclical companies are difficult to estimate – in fact, these companies often show little or no growth in the long term, with investors typically choosing to buy their stocks at the bottom of their cycle and sell at the top. The DCF model is also less useful for companies with lower business predictability ratings, as a history of inconsistent returns often indicates a future of inconsistent returns.
Lastly, companies are unlikely to see the kind of perpetual growth rates assumed by the two stages (growth and terminal) of the DCF model. More often than not, growth fluctuates dramatically from quarter to quarter, year to year and even decade to decade. Companies are not on a set timeline to gravitate toward a mature stage and sit there forever. This uncertainty is why there is so much contention in terms of what qualifies as the “correct” way to construct a DCF model, but the reality is that every model is theoretical in the end.