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One method of determining how much to pay for a stock is the discounted cash flow model aka DCF model. It’s centered on the idea that a company’s value is based on its capacity to generate cash.
I’ve been using this model to help me determine the price I should pay for shares of a company. It doesn’t tell me whether the company merits my investment (i.e., is it a great company?). But if I believe already that the company is worth owning, it allows me to get an idea of how much shares are worth. By determining the value of an individual share of a company’s stock, I can decide whether the current price is fair, a bargain, or ridiculously high. My goal is to purchase shares only when I believe they’re available at a fair price or less.
Why Bother with Stock Valuation
It took me a few years as an investor to realize that developing a target price for individual stocks is a smart idea. At first, I thought that if I bought a good company, then my investment gains would happen naturally, over time. But I discovered that paying too much for a stock meant that growth in the business didn’t translate into growth in stock prices and my net worth.
In one of his annual updates found in Berkshire Hathaway Letters to Shareholders, Warren Buffett says: “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
As a simplified example of this idea, let’s say I buy a painting by an emerging artist for $15,000. I believe that this artist will grow in popularity and her work will increase in financial value, so I don’t bother with calculations or appraisals. At the time of my purchase, an outside firm appraises the piece at $5,000, unbeknownst to me. As I predicted, the artist becomes well known and demand for her art increases. As a result, the value of her art, including the painting I purchased, grows 15% every year. After five years, when I’m ready to sell, the piece is worth $10,000. It’s doubled in value! However, since I bought the painting for $15,000, I’ve lost money on this art investment.
So, even after I’ve located a company with a promising and profitable future, I want to make sure I purchase shares at a good price. Otherwise, I’ll lose money and miss opportunities to build wealth.
Concepts Underlying DCF Model
There are two main concepts that support the reasoning behind discounted cash flow.
Time Value of Money
The time value of money means that the value of a dollar today is different from the value of a dollar in the future. Reasons for this difference including interest, inflation, and potential investment growth.
For example, if I could earn 20% annually on a $100 in an FDIC-insured savings account within a tax-free account, then I’d gladly accept $90 today instead of $100 in one year. That’s because the $90 would grow to $108 [(90) + (90 x 20%]. (Note that I’m using these numbers to illustrate the math, not to claim that I could earn 10% risk-free).
Opportunity cost represents what you’re giving up in order to buy or do another thing.
For example, if I decide to invest in the stock market, then I’m giving up the opportunity to earn guaranteed interest in an FDIC-insured savings account. Further, I’ll need to choose among investments, such as whether to purchase shares of the S&P 500 index fund or an individual stock. Generally, I’d want the potential to earn more in the individual stock as it takes me time to select and evaluate a stock. Also, I want to be compensated for taking on market risk and company risk.
When developing DCF models for stock valuation, you’ll consider opportunity cost (also called required rate of return or the discount rate) when determining the price to pay for a stock.
Numbers Needed for the DCF Model
Here are the numbers I use in developing a DCF model:
- free cash flow
- number of outstanding shares of targeted company
- growth rate during company’s heydays or high-growth periods
- growth rate in perpetuity, generally average economic growth after high-growth periods
- required rate of return (such as risk-free rate plus market premium rate)
Grab Numbers from Reviews of Financial Statements
The first few numbers are gleaned from the financial statements of the company (or companies) I’m considering for purchase. Free cash flow is calculated by taking “cash flow from operations” aka “net operating cash flow” and subtracting capital expenditures.
Typically, the number of outstanding shares can be found on a page with key statistics about the company.
Growth rates are educated guesses, based on the company’s past performance and prospects for the future. I look at growth in revenues, cash flow, and more to project rate of growth.
Determine Required Rate of Return aka Discount Rate
The required rate of return is the minimum return needed to deserve my investment dollars. It’ll be embedded in the discounted cash flow formula as a way of equalizing today’s dollars of my investment money with future dollars generated by the company I buy.
There are many schools of thought about how to determine the required rate of return. Here are a few articles on this topic:
- What is a Hurdle Rate?
- What You Should Know about the Discount Rate
- Discount Rates (PDF)
- Estimating Discount Rates (PDF)
Generally, I simply add the risk-free rate to the market premium rate. If you’re borrowing money to invest in a business, for example, then you’d want to include this borrowing rate in your calculations.
Technically, the risk-free rate is the 30-year U.S. Treasury bond rate (the closest to a guaranteed deal as possible) though I often use a high-yield savings account rate as a proxy. The market premium reflects the return I expect to earn as the result of taking on risk in the stock market. If you feel that there’s additional risk in this investment for which you want to be compensated, then you’d increase your required rate of return.
The Basic Math of the DCF Model
There are a few basic steps to determine the value of shares associated with a company’s stock offering.
- Project free cash flow over the upcoming growth years (generally the next 10 years)
- Determine net present value (today’s value) of cash flow in the growth years
- Determine today’s value of cash flows after the initial growth period until perpetuity
- Combine the current values of cash flow, both the near future and long-term future, to determine the total equity value
- Divide the total equity value by the number of outstanding shares to calculate the value of each share
I compare the share value to the current share price. If the value is lower than the price, then the company’s stock may be overpriced. If it’s higher, then it may be a bargain.
If you want to learn more about DCF models, read The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market.
There are definitely some value judgments that I use in this calculation and stock analysis in general. These include the rate of the company’s growth, whether 5% or 25% for example, and the time frame associated with this growth, whether one year or 10 years. It’s tricky because the subjective judgments involve objective numbers and dollars. But just because I’m using numbers doesn’t mean that my calculations are precise. Instead they give me a general idea of what a business and its stock price may be worth.
I’ve found that using the model, along with gathering information about things like debt, gross margin, and historical return on equity, can help me make better decisions than intuition alone.
How do you decide what you’ll pay for a stock? Do you use the DCF model?