Discounted Cash Flow - How to Value a Stock Using Discounted Cash Flow (DCF) - DCF Calculation

Hi I'm Jimmy in this video I'm gonna walk through how to perform a discounted cash flow analysis on a company. The ultimate goal is to try to determine that company's intrinsic value. This is the first video and our new valuation series. Now I didn't want to just walk through the formula for a DCF calculation and then let everybody fend for themselves. So I'm going to walk through each step and I'll let you know where we can find all the information that I'm using for whatever company that you're trying to analyze. Now this is the actual discounted cash flow formula. And as you can see this formula is supposed to help us calculate the intrinsic value of a stock. Now when talking about the intrinsic value of a stock legendary investor Warren Buffett he said that intrinsic value is an all important concept that offers the only logical approach to evaluating the relative attractiveness of a stock or businesses. So this intrinsic value can be defined simply as the value today of all expected free cash flow from the future. So to try to keep this video as simple as possible I've broken this video into 10 different steps and I'm going to go into each step trying to explain what it is where you can find it or how it can be calculated and some best practices. That being said if you're very familiar with the topic and you want to skip it or if you want to go over something again in description below I've added links to the various sections within the video to try to make navigating the video a bit easier for you. OK now I'm not sure if this is something for you but I'm actually in the middle of creating an Excel spreadsheet template to calculate this exact discounted cash flow calculation. So if that's something you're interested in you can find that over and an investing community website that I'm currently building called investorsgrow.com. There's a link in the description below to that Web site. All you got to do is put it in your email address and then I'll shoot the spreadsheet over to you as soon as it's done. All I ask in return is that you let me email you when the site goes live and then when we issue new updates and things like that. Okay. Good. Now let's get started. So this is what we're after. Our ultimate goal is to try to calculate the intrinsic value of the company also known as the fair value. But before we even get into that the first thing we need to do is to be sure that the company we're analyzing is well suited for a discounted cash flow analysis. So we want the company to meet any one of these four criteria. And then perhaps they'll be well suited for this kind of cash flow analysis. The first one is that the company doesn't pay any dividends and this is actually tied closely to number two and that is that the company does pay a dividend but that dividend isn't anywhere nearly as large as it could be. A lot of companies fall into that category. Now another reason that a company would be well suited for DCF analysis would be that it's discounted free cash flow is nicely in line with profitability. And then finally number four if we are taking a control perspective then using this discounted free cash flow would make a lot of sense. Now don't forget we need any one of these criteria to be met in order for free cash flow to be a viable candidate from a valuation perspective. Now another criteria that isn't on this list and perhaps is overly simple and that is that we want to be sure that the company actually has positive free cash flow. So this would likely eliminate early stage company that have a ton of growth but perhaps they just don't have the free cash flow at this point. On the flip side large blue chip more established companies are likely to be very good candidates for this. Okay. So what I did to get the financial numbers that we need for this analysis is I simply went over to Yahoo Finance and copied and pasted each of the three financial statements over into excel. Now once I did that I did add some colors and did whatever I could to try to make the whole thing look a bit better for the video but all of the data is exactly the way it was in Yahoo Finance. Now as you could see a lot of this data is blank in here and a lot of it's unnecessary. So from a video perspective I'm going to be pulling out certain line items to make them more readable for everybody. But I'll bring it out as we go along. They may notice that I'm using Apple in our example. I figure it makes more sense to use an actual company versus a hypothetical company. Another thing we all need to be careful of is that for some crazy reason Yahoo does the years for a for each company in this order. I don't know why they go the other way they go right to left versus left to right but we're going to be making projections. So we're going to want the data to go from oldest to newest. That being said once I copied all this data over from Yahoo. Onto Excel I switched from the columns to make sure it's done in the proper direction. Okay now let's start calculate. So the first thing we want to do is calculate historical free cash flow. So there are two types of free cash flow calculations. We have free cash flow to the firm and free cash flow to equity. Equity is another word for common stockholders. So free cash flow to the firm is exactly what it sounds like it is free cash flow that is available to the entire firm including bond investors while free cash flow to equity is what's available to stock investors. So as you could guess the primary difference between the two numbers would be interest payments and taxes. We're going to be using free cash flow and equity now free cash flow to equity is good to use as long as the leverage of the company. Here you're analyzing is fairly stable and here's why. The first thing we need when analyzing free cash flow is cash flow from operations. Now for Apple we can see that it's this seventy seven billion dollar number right here. Then we subtract capital expenditures. Capital expenditures comes from the second section in the cash flow statement. So when we do the math we can see that we end up with about sixty four billion dollars in free cash flow. Now technically this isn't correct. This is an estimate. Technically we're also supposed to add net borrowings to the whole mix. So a cleaner formula would be to do cash flow from operations minus fixed capital expenditures also known as capex. And then you add net borrowings. Now we can see that when we adjust these numbers to a account for net borrowings in 2018. Well it doesn't affect things all too much but when we look at previous years what we can see that Apple had taken out large amounts of debt in the past few years and that's significantly impacted their free cash flow and made it look much larger. Now the reason this formula is more accurate is that technically let's imagine that a company went out and borrowed a bunch of money. Well if they wanted to they could use that borrowed money and they could pay dividends. And since free cash flow to equity is how much cash is available to stockholders. Well then in theory that borrowed money would be available to the shareholders. It would not be available in free cash flow to the firm but it would be available in free cash flow to equity. Now many Wall Street analysts that I know don't do it this way. They do it the simpler way. They simply take cash flow from operations and they subtract capital expenditures. And one of the major reasons why they do that is because when we forecast free cash flow like we're going to do in a second well we'll realize that it's very difficult to predict when a company is going to have net borrowings. Okay. Now lets project out free cash flow. Now once again there are a few different ways to do projections but I'm going to stick with the way that is simple and it comes up with a fairly effective result. So you may remember a few minutes ago when we rattled off the four different reasons why free cash flow might make sense to use on a company. Well one of those reasons was that the free cash flow of that company was in line with profitability. So if we look at that for Apple Well we take our calculation of free cash flow. By the way we're using the simpler version of the calculation and then we compare that to net income. So we do free cash flow divided by net income. Here we could see that each of these numbers for the past four years are about in line with net income. In 2015 it was a hundred thirty one percent twenty sixteen hundred seventeen percent and then it was a hundred seven hundred eight percent in each of the next years. Now ideally what would have happened is that when we were doing our research and for whatever company you were analyzing well perhaps we have developed an opinion as to where we believe that business is going and that would ultimately lead. It would help sway our decision as to whether or not we believe free cash flow will continue to act as it has relative to profits for Apple. In my case well I've done some research on the company and I have no reason to believe that Apple's free cash flow was going to be terribly different than it has relative to profits than it has in recent years. That being said I think it makes sense to use the one hundred and seven percent number that's the lowest number in the past four years. So using a lower number would make our estimates a more conservative estimate. Okay. Now let's go ahead and try to come up with our projections. So once again there are a few different ways to get to the numbers that we need now. We can either try to project net income and then derive free cash flow off of that or we can project revenue and that will lead us into net income and then come up with free cash flow. Now I'm going to use revenue I'm going to project revenue just to illustrate how it could be done but if you want to try for net income you could do the same thing. Same concept would apply now for a company like Apple that has many analysts covering it. One thing we could do is go back over to Yahoo Finance and look at their analyst's projections so we can see that they have revenue for 2019 to be estimated to be about two hundred and fifty seven billion. And that comes from 33 analysts. So I like our sample size. Now in 2020 they have us estimated to be at two hundred and sixty nine billion. Okay. Simple enough. So let's use those first two years in our projections and then with that we're going to use another popular method for forecast. Now let's imagine that we don't have access to any analyst projections or we don't know if we can trust the analysts that are doing the projections either way one simple and very logical method of coming up with projections is to simply identify a reasonable growth rate. So in this case we want to project revenue. Now this would work for either revenue or net income you could apply the same method to both. So what should our growth rate be for revenue for the two additional years that we're gonna come up. Well we could take the average of what analysts expect to happen in the next two years. And if you look at theirs there's are a negative 3 percent growth rate in 2019 and a positive 5 percent growth rate in 2020. Average those out we end up with a positive 1 percent growth rate. Now that could work but if we want we take an average of all five years and if we do that we end up with the 3 percent average to me 3 percent seems reasonable. Apple is a huge company. It's going to be tough to grow at a big rate for any long period of time. Now I could probably make the case that 3 percent is a bit on the low end but I like being conservative. OK so if we apply a 3 percent growth rate to our final two years or we take the two hundred sixty nine billion from 2020. Multiply that by one point zero three we get two hundred seventy seven billion. Then we take that number in 2021. Multiply that by one point zero three. And that grows to two hundred eighty six billion in 2022. Now I'm going to stop here as far as projections go. But if we wanted to keep going perhaps or analyzing a company that is smaller than Apple and we think that they have fantastic growth prospects for the next couple of years then maybe we could extend this beyond just the next four years we could add multiple growth rates for various time periods based on what we believe would happen now. Be careful about getting too cute with that type of thing because the further we go out the more uncertain our estimates are going to become. OK. So now we have a revenue estimates and now we need to convert that into net income estimates. Now we could do exactly what we did for revenue. Ultimately we could just go find analyst estimates extend beyond that find a growth rate or we would do a combination of the two like we did for revenue. But there's a different way of doing it that I think is more logical once you have revenue estimates. So now we want net income margins to calculate that. We pulled net income off of the income statement and revenue off of the income statement. We divide net income by revenue and what we end up with is net income margins. Now this actually turned out really well for Apple because Apple consistently puts up similar net income margins. So if you were to average out these four years will we get 22 percent average. Now for me I'm a bit more conservative so I'm actually going to use the 21 percent number just to be conservative. But if you wanted to use twenty two percent you could do that as well. So now we take our projected revenue and we multiply it by net income margins in our case 21 percent and just like that we come up with projected net income then we take our free cash flow rate which we decided was going to be one hundred seven percent. We multiply that by net income and just like that we have projected free cash flow going out the next four years. Okay. Moving right along. So now we can enter our free cash flow numbers into our. Just kind of cash flow formula. And that complete step two. Don't worry the future steps are actually much faster than the early steps. Once we get to the end we're going to be flying right along. Okay. So now it's time to come up with our required rate of return. Now calculating required rate of return is actually interesting since we're using free cash flow to equity. We are supposed to be discounting that our required rate of return is supposed to be based on our individual perspectives. So it's going to be based on our investment goals our time horizon our available capital risk tolerance the list for things that could influence that go on and on. So if you happen to know what your required rate of return is then by all means that's what you should use. But if you're not sure of what to use as far as the required rate of return goes Well typically we can determine a sort of general required rate of return. And they do that using something called the weighted average cost of capital. It's sort of a default required rate of return. Now for somebody like me who makes videos and couldn't possibly come up with a fair required rate of return on an individual basis for different people. Well for me it makes sense to use the weighted average cost of capital. Now typically it would be the company that would use a weighted average cost of capital and you would apply that to the free cash flow to the firm not to equity but it can work this way. Now I've made short videos on both the weighted average cost of capital and the Capital Asset Pricing Model and those are key concepts to coming up with the required rate of return. So if you're interested in learning more about them you can find the links in the description below. So this is a formula for the weighted average cost of capital. The W's stand for weights and the little d and the little e that represents debt and equity the first section is debt the second section is equity. Now the R is the rate that we're trying to calculate for both debt and debt. Now we're gonna run through where we get the information for each of these. So how about we start the debt now. Generally if we're looking for the weighted average cost of debt we should be able to find that in the company's annual filings if not a crude way of computing it would be to take the company's average annual interest expense and compare that to the company's total debt. Now this only works if the company hasn't issued a ton of debt in this year. But in Apple's case we saw on their cash flow statement that their net borrowings was fairly low for this year. So this should work just fine. So we take their interest expense line item from the income statement for 2018 and we compare that to their total debt. We get total debt by looking at short term debt and long term debt off the balance sheet. When we calculate that we end up getting an average rate of about three point two percent. Now that makes sense that's a type of rate that Apple would be paying. So we're gonna go with that but we can't just take this amount the way it is. Yes they pay three point two percent on their debt but in most countries interest expense is a tax deductible item which means the company will pay less taxes because of that interest payment which means that three point two percent isn't the true cost of the debt. That's what is one minus t represents in our formula. The T stands for taxes. So to calculate the tax rate we take the income tax expense from the income statement and we divide that by income before tax. Also on the income state now we get a calculated effective tax rate of eighteen point three four percent. Now if you would compare this to the numbers listed in there 10 K because most companies are gonna list their effective tax rate there as well. Sure enough Apple gives us eighteen point three percent. So they just ran to that number differently than we did. So now we take our three point two percent cost of debt and we multiply that by one minus t we get a cost of debt of 2.58 percent that's the debt we want to use that state tax adjusted cost of debt. Okay. So now we have the cost of debt. Now we're gonna need to calculate the cost of equity to do that. We're going to use the Capital Asset Pricing Model. This is the formula for the capital asset pricing model. The first thing that we're gonna need. We're gonna need a few different things first but the first thing is gonna be the risk free rate. Now we can get that in a lot of places and I'm gonna try to stay consistent here so I'm going to go to Yahoo Finance for. There we can find it under markets then we go to the U.S. Treasury bond rates and then once that loads we could see that we want the 10 year U.S. Treasury rate right now that is at about two point three two percent. That's generally accepted as the risk free rate. So now we plug that into the formula here under both of these sections. Next we need beta for the stock. In Yahoo Finance. We could find beta on the statistics page for apple there. They list beta to be zero point eight nine. Now we can plug that into the formula right here. Now we need the expected return in the market. Now this one's a little bit trickier because there's no real clean place to find that. So what I did is I pulled down the average returns of the S&P 500 going back as long as I could find. So I broke it up by different time periods and then we can elect to use whichever one we think is most appropriate. So I don't think you'd be smart to use the 15 percent which represents the past 10 years because we're more than 10 years away from the Great Recession. So in theory the past 10 years have been so good because it coming off the lows after the Great Recession. Now if we use a 20 or no well that's 6 percent number since 1999 is sort of the opposite of that. That was right at the high right before the tech bubble burst. So in that 20 year number essentially what we get is we get the crash of the tech bubble another rally the before the Great Recession the Great Recession and the rally since then. So I'm not sure that's a fair representation either. Now if we're just eyeballing the rest of these numbers I personally think it makes sense to use 10 percent now. Just so on the same page 10 percent. Isn't the expected return this year or the expected return next year it's the average expected return over a long period of time. So if we have reason to believe that the number will be lower than that or higher than that by all means adjust this number accordingly. OK. So now we have all of our components for the Capital Asset Pricing Model when we plug them all in and we calculate we end up with nine point one six percent. Now we need to wait for both debt and equity and this is actually quite simple. So we take the market cap which represents the equity and then we take the total amount of debt out there that represents the total debt. Apple has a market cap of about eight hundred twenty six billion and they have debt of about one hundred and twelve billion. We add these two up and we get a total amount of capital in the company of about nine hundred thirty nine billion. Now we simply take the hundred twelve billion which represents a debt and we divide that by nine thirty nine and we can see that that represents about 12 percent of the total capital structure. Equity therefore is about 88 percent. So now it's time for some basic math and we could see that a weighted average cost of capital is eight point four percent. So now we're going to plug that number into the required rate of return fields on our original DCF calculation. Next up we need shares outstanding. So if we go over to Yahoo Finance we could see that they say it's four point six billion shares outstanding. And frankly that's a bit vague. Now if we go to the company any companies most recent annual or quarterly filing well in one of the first two or three pages we can find all the way at the bottom the exact number of shares outstanding. So I'm simply going to take that copy and paste it over into our formula. Now one thing to realize with this is that the financial numbers are in thousands while this is an exact number. So we've got to remember chop off the last three numbers here. So plug that into the formula. And this brings us to the last point the key data that we need and that is our perpetual growth rate. So you might also hear is called the constant growth rate. And basically the perpetual growth rate is the growth rate that free cash flow is going to grow at for ever. Now my personal favorite free cash flow perpetual growth rate is 2.5 percent. That's about in line with the expected growth of the U.S. economy most global most developed global economies. Either way I'd say it's a fairly safe number to use. It's probably a bit on the conservative side. Now the key to this whole thing is to make sure that the number is not too large imagined we used 5 or 6 percent let's say we use 6 percent. So if the economy the global economy is growing at 3 percent and we use 6 percent we're implying that one day this company would be larger than the global economy. And that just seems a little bit crazy. OK. So now we have all of our key data now. Our goal is to calculate the present value of each of our expected free cash flows. So 2019 is time period 1 2020 is time period 2 and move right down the line. So now we need to calculate our terminal value. So this is the formula for terminal value calculation. And basically what we do is we take our last time period. In our case it's time period for and then we take our final free cash flow and we grow it one year by our perpetual growth rate. So at that point we're going to assume that everything grows at that point from our perpetual growth rate of 2.5 percent. So one point zero to five times are sixty six billion dollars in the final year. Now this number is essentially time period five's free cash flow. So now we take that time period five's free cash flow and we divide that by our required rate return which is eight point four percent minus our perpetual growth rate which is 2.5 percent. That total that's five point nine percent. So we divide time period five's free cash flow by our five point nine percent or zero point zero five nine and we end up with our terminal value but below for one point one trillion. Now technically this one point one trillion is the time value at the end at the end of period for the beginning of period 5. That's what that formula did it moved into the beginning of the period. Okay. So now we have the free cash flow for each time period. And don't forget the terminal value and the 64 billion in 2022 are the same time period we just separated them so we can see it now. Now I believe that the easiest way to calculate this at this point is to come up with a discount factor. Now the way we can do that is we take the required rate of return in our example you were using a weighted average cost capital of eight point four percent and we add one to it. So we get a one plus point zero 8 4 and then we've raised it to whatever time period we're in. So if it's time period for you raise the power for a discount factor in 2019 is one point 0 8 4 race to the power of 1 2020 which is time period 2. Same thing except this time raise to the power 2. That gives us 1.175 and then we keep doing this discount factor into we had our time period for which is 1 point 0 8 4 race to the power of 4 gives us about one point 3 8 1 and then we simply take the free cash flow from each time period and divide it by that discount factor and then we will get the present value. As of the start of our calculation. So we perform this calculation on each of our time periods. And don't forget the terminal value gets discounted by time period 4 and then all we need to do is we need to add up each of these discounted cash flow numbers to give us today's value. We take today's value and we divide that by the number of shares outstanding and we get the intrinsic value of Apple stock today. Now this brings me to some holes in the discounted cash flow valuation. Now the biggest issue with calculating DCF is the amount of assumptions that have to be made to come up with the calculation Personally as I've said before this is my favorite calculation to use. But even though there's a ton of assumptions I think that if we're conservative throughout our whole process it tends to lead to pretty good results now. The whole calculation is very sensitive to the inputs that go into this whole thing. So we need to be very aware of that. So for you to adjust our perpetual growth rate or our required rate of return you'll see when you do this type of calculation how much this swings things. That being said it might make sense to do what they call a scenario analysis or a sensitivity analysis sensitivity analysis is basically where you say OK based on our 1 percent move in any direction for the different variables that go into the formula. How would that impact things. I personally like to play with that once I have the excel sheet all set up I like to play with it and see how it impacts things and then try to pick the most conservative number. Now if we pick our conservative numbers and we get a discounted free cash flow number of fair value of the stock of the intrinsic value of the stock that we like the next step. The final step would be to place our own personal margin of safety to that number. Now you could in theory apply a margin of safety to the different components but I don't really like doing it that way I don't think that makes a lot of sense. I think it makes far more sense to come up with the fairest version of the calculation as you can and then you add a discount to that final number and say OK I want to buy it less than that now the reason any investor professional investors like Warren Buffett or normal investors like you or I. Well we're going to want to add a margin of safety because we understand that there were certain guesses made in this whole calculation. So we want the more confident we are the less confident we are the bigger the gap the more confident we are you can have a smaller gap. Either way I'd suggest that one thing we want to be careful of is make sure we don't mess with the inputs too much to get the numbers what we want them wait for the stock to fall to the price that you really should be buying it at for two to meet your personal required rate of return. So that wraps it up I hope you found this interesting. If you haven't done so yet hit the thumbs up. Hit the subscribe button. Thank you for stick with me all the way to the end of the video. If you're interested in the template for the Excel spreadsheet come over to invest it grow. Plug an email I send it to as soon as I can. Thank you very much I'll see in the next video.

Channel: Learn to Invest - Investors Grow

Views: 696,018

Keywords: Investment Ideas, learn to invest, investing for beginners, dcf, company valuation, discounted cash flow, how do you value a firm?, discount factor, discount rate, stock value, intrinsic value, valuation, stock valuation, security analysis, investments, how to calculate discounted cash flow, how to calculate dcf, how to calculate intrinsic value, stock pricing, discounted cash flow analysis, discounted cash flow analysis template, free cash flow to equity, fcf

Id: fd_emLLzJnk

Length: 27min 32sec (1652 seconds)

Published: Tue May 28 2019