Would you rather receive $100 one year from now? Or would you want to receive it today? The correct answer of course is today. That's because money loses value over time due to inflation and the opportunity cost of investing it. Well, the point of DCF analysis is to forecast future free cash flows of an investment/company and then discount them back into the present in order to find out what the future money is worth today (present value). If the present value of the future free cash flows are greater than the current cost of the investment, then it is considered a good/undervalued investment.
Choosing a Discount Rate For Your Calculation
In order to find out whether the investment is feasible, you have to discount its future free cash flows using a discount rate. So how do you choose the discount rate? The proper way is to use a company's weighted average cost of capital (WACC). WACC is the weighted average of the cost of a company's debt and the cost of their equity. To read our blog post about WACC, click here.
Cost of debt is essentially the interest rate of what it would cost a company to raise debt (issue bonds, debentures).
Cost of equity is a theoretical rate of return required to satisfy equity investors (shareholders) based on the risk of the company.
Cost of equity is not a tangible number that can be exactly calculated since it's a theoretical estimate. It is often calculated using the Capital Asset Pricing Model (CAPM). At times, the CAPM model can be flawed especially in this low interest-rate environment because it has the potential to calculate a very low cost of equity such as 2% (depending on the company). I personally don't think any stock is safe enough to have a 2% cost of equity and in that scenario I would raise the cost of equity to a number that makes more sense for that company (my rule of thumb is a minimum 5% cost of equity). Safe corporate bonds pay around 2% yields, so why would you invest in a stock for 2%? Individual stocks also carry company and industry-specific risk that you will be exposed to unless you are diversified into many different stocks. This is why sometimes a more common-sense based approach is better to calculate cost of equity rather than relying on CAPM which can calculate artificially low numbers. If the CAPM calculation makes sense to you, use it. If not, adjust that yourself based on your personal required rate of return for that stock and then combine that with the cost of debt to get the WACC.
Let's assume you calculated that a company's WACC is 7%. You would then use 7% as a required rate of return for your calculation (discount rate and required rate of return are interchangeable terms). This means that you would require a 7% annual return for the investment to be "fair value". WACC goes beyond the scope of this blog post as it would require a lot more explaining in order to fully understand how to calculate it. This is just an introduction to get you more familiar with DCF valuation.
How to do a DCF Calculation For Stocks Using Unlevered Free Cash Flow
DCF valuations can either be done using unlevered free cash flow (FCFF) or levered free cash flow (FCFE). For the purpose of this blog we will only be going over the way to calculate DCF using unlevered FCF as we feel it is a more accurate way of calculating intrinsic value. However, the formula below applies to both unlevered and levered FCF where the "CF" in the formula would be replaced with either FCFF or FCFE depending on which type of FCF you are using.
The formula for DCF is as follows:
CF = Cash Flow
R = Discount rate (WACC)
In unlevered DCF valuation, you are forecasting the future unlevered free cash flows for a specific period of time (for example the next 5 years), discounting them, and then adding them all together. After adding all the discounted cash flows, you then calculate a terminal value of all the future unlevered free cash flows. Then, you add the two numbers together and this gives you a fair enterprise value for the company. Lastly, you subtract total debt of the company from the enterprise value you calculated and that gives you the fair value market cap of the company (example below).
A terminal value is a calculation of the present value of all the future free cash flows going into perpetuity (unlimited number of years). To find the terminal value, you have to assume a perpetual growth rate for the company. The perpetual growth rate should either be around historical inflation levels or less than GDP levels. Usually, a perpetual growth rate is around 1.5-2.5% depending on how aggressive you want to be with the valuation. Anything higher than 2.5%-3% may be too aggressive in the valuation, which could potentially give the company a higher valuation than it deserves.
In unlevered DCF analysis, the terminal value formula is as follows:
Final Year Discounted UFCF * (1 + Terminal UFCF Growth Rate) / (WACC - Terminal UFCF Growth Rate)
= Terminal Value
Example of a 5-Year Unlevered DCF Valuation
Market Cap: $100 million
Total Debt of Company: 15 million
Discount Rate (WACC): 10%
2020 est. unlevered free cash flow: $10 million
2021 est. unlevered free cash flow: $12 million
2022 est. unlevered free cash flow: $12.5 million
2023 est. unlevered free cash flow: $13.5 million
2024 est. unlevered free cash flow: $15 million
We have our forecasted free cash flows, now we have to discount these cash flows using the DCF formula above.
Year 1 (2020): 10,000,000 / (1+0.10)^1
Year 2 (2021): 12,000,000 / (1+0.10)^2
Year 3 (2022): 12,500,000 / (1+0.10)^3
Year 4 (2023): 13,500,000 / (1+0.10)^4
Year 5 (2024): 15,000,000 / (1+0.10)^5
Add those numbers and you get: $46,934,199
Then, you need to calculate the terminal value using the formula above. We will assume a perpetual growth rate of 1.75% per year for this company.
Terminal value = 9,313,819 * (1+0.0175) / (0.10 - 0.0175)
Then, add the terminal value + the 5 years of cash flow to get the fair enterprise value: $161,804,633
Lastly, subtract the debt of the company (15 million) from the enterprise value to get fair value of equity: $146,804,633
Final valuation of company XYZ: $146,804,633 market cap.
The current market cap of $100,000,000 would mean that this company is undervalued.
Problems with DCF Valuation:
As you've probably noticed, DCF involves some assumptions which are bound to be inaccurate. You assume the perpetual growth rate of a company, forecast future free cash flows based off of multiple factors (or use analyst forecasts if you don't want to forecast yourself), and estimating cost of equity using CAPM isn't always a great idea in my opinion.
Also, the fair value estimation is highly sensitive to the discount rate you come up with so it is important that the discount rate is as "accurate" and as logical as possible. DCF is also not as useful for some industries such as financials, as a better way to value financial stocks is by using the Excess Returns Model.
Lastly, DCF can be highly inaccurate for companies with negative free cash flow or start up companies with not much history to look back to for the purpose of forecasting future cash flows. It is most accurate with stable companies that have a predictable business model and a long history of stable free cash flow. Nonetheless, DCF is one of the most important and utilized style of valuations, and it should be taken into consideration when valuing a company.
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