Motley Fool Hidden Gems Investing - How to Value a Company with the Discounted Cash Flow Model

Episode Date: April 16, 2022

Grab your notebook and get ready to dive deep.  Motley Fool Senior Analyst John Rotonti discusses how investors can value a company using the discounted cash flow model. This method is the fundamental way to determine if you’re getting a bargain or paying too much when you buy any stock.  Rotonti discusses:   - How to pick a discount rate for investments.  - The key difference between fair and intrinsic value. - How to project free cash flows.  Have an investing question for John? Call 703-254-1445, leave a voicemail, and he may answer your question in an upcoming episode.  Additional resource: https://www.fool.com/investing/2022/01/19/expectations-investing-qanda-mauboussin-rappaport/  Stocks discussed: IBM, NEE, PEP Host: John Rotonti Producer: Ricky Mulvey  Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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BetMGM operates pursuant to an operating agreement with iGaming Ontario. run it out year one to year 10. I'm Dylan Lewis, and that was Motley Fool analyst, John Ratante. Today, we're continuing John's series on navigating major financial statements with a breakdown of how to build and understand a DCF or discounted cashflow model. I'll confess that I've built exactly one DCF in my entire life. It was for a college finance class. And honestly, I may never make another one. Even if you're like me, this conversation is for you. Because throughout John's overview of modeling cash flows, he provides mental models and the questions you

need to ask yourself when you're looking at companies. Understanding how those inputs affect the company's path forward will make you a better investor, even if you never open an Excel spreadsheet. Before I turn things over to John, we also want to know what investing questions you have. Give us a call at 703-254-1445, and leave us a voicemail with your name, city, and whatever question you may have. He may answer it on an upcoming show. That number is 703-254-1445. And now, here's Professor John Rotonti. Hello Fools, John Rotonti again and today we are going to talk about valuation and in particular a discounted cash flow valuation also called a DCF for discounted cash flow. So

the first thing we need to understand is the definition of intrinsic value, the definition of fundamental business value. When I say intrinsic value, I mean the business value, the estimated business value based on the company's fundamentals, okay? So fundamental business value, intrinsic business value, they mean the same thing. And the definition of intrinsic value is the present value of future free cash flow that a company will generate. Why present value? Present value because everything in corporate finance is pretty much based off present value. Present value says that a dollar today is worth more than a dollar in the future because you can invest that dollar today and earn some interest

on it and so what we're going to be talking about in a second is estimating a company's free cash flows far out into the future and so we need to convert those far out into the future free cash flows to their present value this is one of the primary pillars foundational pillars of corporate finance and valuation this idea of present value okay so the definition of intrinsic value which is what we're talking about when we're talking about valuing a business is the present value of future free cash flows if we said that a different way it would be that the intrinsic value of a business is all of

the estimated future free cash flows of the business from now until the end of the life of that business, discounted back to their present value. I just said the same thing in two different ways. Okay, the three primary things you need to know about a discounted cash flow model are DCFs are based on the size of the free cash flow, number one, the timing of the free cash flow, number two, and the riskiness of the estimated free cash flow number three. So, GCFs are based on the size of the cash flow, the timing of the cash flow, and the riskiness of the cash flow. What do we mean by size? Well, ten million dollars in free cash flow in

any given year is worth more than one million dollars in free cash flow. So, size matters, fools. When you're doing DCFs, size matters. Timing. We just talked about the present value concept. Well, timing. $10 million in free cash flow one year from now is worth more than $10 million in free cash flow 10 years from now. I want to say that again. Because the further out you get, the lower the present value of those free cash flows are. And then the third thing is the riskiness of those free cash flows. We incorporate the riskiness of a business into our discounted cash flow models with something called a discount rate. A discount rate is also sometimes referred

to as a hurdle rate. A discount rate is also sometimes referred to as a cost of capital or a weighted average cost of capital. For the purposes of this podcast, discount rate, hurdle rate, cost of capital, and weighted average cost of capital, or WAC, all mean the same thing, okay? the discount rate is what we divide or discount those future free cash flows back to present value to bring future free cash flows back to present value we need to do a simple division and we need to divide by a discount rate okay the more risky we believe a business is the higher the discount rate we want to use the less risky a business is the lower the discount rate we want to use so

riskiness of the business is incorporated into the DCF model through the discount rate. Now, this is incredibly important. Think of the discount rate as your required rate of return. So there's a fifth synonym. We have discount rate, we have hurdle rate, we have cost of capital, we have weighted average cost of capital, and I just give you a fifth one, required rate of return. If a business, if you deem, and this is a personal decision, This is you. I'm talking to you, the individual fool out there. If you deem the business risky, then you are going to require a higher rate of return to invest in that business. Therefore, you're going to use a higher discount rate. If you deem the business less risky,

then you may require a lower rate of return to invest in that business let's put some numbers around this the stock market has historically returned on a nominal basis before inflation nine descent nine to ten percent per year on average nine to ten percent per year on average most investors want to beat the stock market by a little bit and so their required rate of return for the average business for the average risk level business it's going to be slightly higher than nine to ten percent right because the stock market they can get nine to ten percent on average over time just investing in an index fund so if

they're gonna take on the extra risk and put in the extra time and effort to pick individual stocks then they're going to probably try to beat the market by a little so if the stock market has returned about nine to ten percent on average per year over a long period of time then maybe you want to discount stocks at 10 to 11 for your average medium risk level business but we're living in weird times right now fools because interest rates until two weeks ago We're set at the zero bound. Interest rates were at near historical record lows. Okay.

Because interest rates are so low, because the interest rate you could get investing in a U.S. Treasury bond or the interest rate you could get investing in a highly rated corporate bond is so low, Stock investors were willing to lower their required rate of return. So very few investors were using the 10 to 11 percent required rate of return or the 10 to 11 percent discount rate we just discussed because interest rates were so low they lowered their discount rates, they lowered their required rates of

return to somewhere around six to eight percent let's say. But that's a personal decision. But if you were valuing PepsiCo or NextEra Energy, low-risk businesses or lower-risk businesses, you may want to use a lower discount rate, something in the 6% to 8% range. If you were investing in a startup early in its life cycle, unproven, hasn't proven it can scale yet, not earning any money, burning through cash, not self-funding, highly reliant on capital markets to grow because it's not self-funding, then you're going to use a higher discount rate. You're going to have a higher hurdle rate. You're going to have a higher required rate of return to put your dollars in that company. These interest rates, these required rate of returns,

these discount rates this is the essence fools if you're investing in a company that is highly dependent on commodity prices and so doesn't really have a control over its key input cost or if you're investing in a company that operates in a highly cyclical highly commoditized industry prone to boom and bust cycles then you're going to have a higher required rate of return you're going to use a higher discount rate in all likelihood but that's a personal decision now this gets even more important discount rates and free cash and present values of free cash flow move in the opposite direction so the higher the discount rate the lower the present value of future free cash flows

so the and the lower the present value of future free cash flows the lower your estimate of intrinsic value will be let's take the opposite the lower your discount rate the higher the present value of future free cash flows will be and the higher the present value of future free cash flows will be, the higher your estimate of intrinsic value will be. So discount rates and intrinsic values are inversely related, fools. The higher the discount rate you use, the higher your required rate of return, the lower your estimate of intrinsic value will be. The lower your discount rate you use or the lower your required rate of return the higher your intrinsic value will be so if you model out a business which we'll get to in a second you do a dcf you estimate out the

free cash flows from now until the end of the life of that business and the only thing you change in the model is the discount rate at which you bring those future free cash flows back to present value If the only thing you change in the model is that one cell, that one Excel cell in the Excel model, if the only thing you change is the discount rate, the higher that you put that cell, the higher you put that discount rate, the lower your intrinsic value will be. Literally, you can go into Excel, change the discount rate in that one cell, and hit enter, and your intrinsic value will drop. I guarantee it. It's just math. If you go into that cell and you put in a lower discount rate

in that cell in Excel, your intrinsic value will increase after you hit enter in that model. Let's get into the model. We separate a discounted cash flow model into two parts. the forecast period, also called the projection period, and then the terminal value period. The forecast period, or projection period, is the period in which we are actually putting in our assumptions for what we think revenue will be in each year of that forecast period. Most models that I have seen have a forecast period of anywhere from five to ten years.

Why do they stop at ten years? Two reasons, I would say. One is because our crystal ball goes pretty dark after ten years, right? It's really hard to estimate what a company's sales and margins are going to be ten years from now, much less three years from now, okay? so that's the first reason the further out your projection period is the further out your forecast period is the less conviction you're going to have in your assumptions on those far-out years because our crystal ball just goes dark

the other reason is because the best most proper way I think to do a free cash flow model is to make your projection period as long as you think the company can maintain its competitive advantage this is called a cap CAP or competitive advantage period this is the amount of time measured in years that you believe a company can maintain an excess return spread what do we mean by an excess return spread it means the amount of time measured in years that you think a company excuse me can generate a return on invested capital which is a measure of profitability and performance it's the amount of time

measured in years that you think a company can maintain a return on invested capital that is higher than its cost of capital. So the best way to do a DCF is to use your projection period to set your projection period or your forecast period to the number of years that you think and this is just you know an educated guess at best that you think a company can maintain its competitive advantage meaning the amount of years the amount of time measured in years that you think a company can generate a return on invested capital that is higher than its cost of capital okay but most DCF models are ten years so for the purpose of this we're gonna use ten

years. Then in the terminal period, this is the second part of the DCF, okay? In the terminal period, we're using a mathematical formula, which is called a perpetuity, to estimate the cash flows from year 11, the very next year after our projection period. Because remember, for the purposes of this podcast, we're using a DCF of 10 years for the forecast period. So the terminal value or the terminal period calculates the free cash flows from year 11 into perpetuity. That's the only way we can do it, right? Because we just don't know what a company is going to look like in year 30 or 40 or 50 or 100 if it's going to be around that long. And there are companies around that long, right? IBM. There are definitely companies around that

long but we can't estimate out sales and margins in year 100 and so we use this mathematical shortcut because it's the best option that we know of today what happens in the projection period so you have your one year two year three year four year five year six year seven year eight year nine year ten okay that means we need to estimate how fast we think the company is going to grow its revenue in year one. So, one year from now. How fast we think it's going to grow its revenue in year two, how fast in year three, how fast in year four, how fast in five, six, seven, eight, nine, and how fast in year 10. This revenue rate should fade down as you get to year 10,

as you get to the last year of your projection period. Okay. So all we do is take the revenue that we currently have, right? Multiply it by the growth rate that we think it's going to grow at, or multiply it, sorry, by one plus the growth rate that we think it's going to grow at one year from now, and you get an estimate of revenue one year from now. And then you take revenue one year from now, multiply it by one plus what we think the revenue growth rate will be two years from now, and you get revenue, estimate revenue two years from now. And then you take our estimate of revenue two years from now, multiply by one plus your estimate of what you think revenue growth will be in year three, and you get estimate revenue

growth three years from now and on and on until you get to year 10, which is the last year of our projection period. That's it. So now you have modeled out revenues for the next 10 years. The next line down in a traditional DCF is the EBIT margin or the operating margin. We talked about EBIT margins in our segment on financial statement analysis when we talked about the income statement. Okay? So now you need to estimate what you think the EBIT margin will be in year one, in year two, in year three, four, five, six, seven, eight, nine, and ten.

Maybe you think this company has a lot of margin expansion opportunities as it scales up and achieves economies of scale and unlocks that operating leverage. So maybe you have operating margins slightly increasing every year from year one through year 10. Maybe you think margins are going to remain pretty stable because it's a pretty stable industry.

Market shares don't shift that often. The players in the industry are rational about their pricing. they don't get into pricing wars, and maybe the industry's just been around a long time and you think pricing is going to remain stable. That's fine. You just pick an operating margin or EBIT margin for year one and run it out across the next nine years to year 10. Maybe you think this company is in secular decline. Maybe you think it's got a weakening competitive advantage. Maybe you think competition is going to take share. In that case, the company may have to sell stuff at a discount to maintain growth. It may have to give stuff away. It may have to

discount items. In that case, you think operating margins, even margins may decline slowly or not so slowly over the next 10 years. In either of the three cases, you have now estimated an operating margin that you think the company can achieve for each of the next 10 years. And remember, we just estimated, these are all estimates, all of them, okay? We just estimated right before that what we thought revenue would be in each of the next 10 years. So now you literally take the operating margin that you just estimated in year one, multiply it by the revenue that you just estimated in year one and you get your operating income or your EBIT in year one and then you take the revenue that you estimated in year two,

multiply it by the operating margin that you estimated in year two and you have operating income estimate for year two and then you take the revenue you estimated for year three, multiply it by the operating margin you estimated in year three, and you get your estimated operating income in year three. And you do that on and on every year through year 10. The next step is pretty easy. Don't try to be a hero. You have to pick a tax rate, right? Just pick, get some good industry-level data, see what the average tax is that the company you're valuing has paid over the past five years or so.

See what ways that tax rate has been trending, has it been trending up, has it been trending down. Understand what is driving the change in that tax rate. See what the industry-level tax rate is, what the average peer tax rate is. Pick a tax rate, run it out year one to year 10. Keep it the same unless you think there's going to be some major change to the corporate tax rate at some point over the next 10 years. Honestly, don't be a hero. Just pick a tax rate and run

it out every year for the next 10. Then you take the operating income in year one, multiply it by the tax rate in year one, and you get this all important number called NOPAT. N-O-P-A-T. Just net operating profit after tax. It's just your operating income after tax. No PAT. Then you do the same thing for year two. You take your operating income year two, multiply it by the tax rate year two, and you get your no PAT year two. You do the same thing year three, four, five, six, seven, eight, nine, ten. Next line down, we're almost done. We're almost at free cash flow, literally one more line and we're at free cash flow, okay?

So we have NOPAT, after tax operating income. Now we need to subtract reinvestment into growth. If you remember from our financial statement analysis podcast, we defined free cash flow as the amount of excess cash flow left over after a company has reinvested to maintain and grow its business. So from NOPAT, we have to subtract total reinvestment

that we think the company is gonna make in year one, year two, year three, all the way through year 10. What is included in that reinvestment? Changes in working capital from one year to the next, capital expenditures, property, plant, and equipment, acquisitions. Those are the three big ones. R&D was already included in NOPAT. So that is already included in your operating income. So you subtract from NOPAT, you subtract what you think reinvestment will be. Remember, working capital changes, capex and acquisitions, and you get free

cash flow. So now we have free cash flow, fools, modeled out in an Excel model from your 1 to your 10. These are estimated free cash flows in your 1 to your 10. Now you have to pick your discount rate or your required rate of return. Let's say you pick 8%. Let's say that's your required rate return because interest rates are still so low and now you just need to discount the free cash flow in every year year one to year ten by your discount rate and the way you do this is you take the free cash flow in any given year so free cash flow year one as your numerator okay free cash flow year one is your numerator you divide by one plus your discount rate raised to the year this is

your one okay so you would divide your free cash flow estimate for your one divide that by one plus point oh eight raised to the one and that gives you the present value of that free cash flow for year one then you do the same thing in year two. You take your estimated free cash flow year two, divide that by one plus 0.08 and raise that to the two to get the present value of that free cash flow. And then for year three, you take your estimated free cash flow year three as your numerator, divide that by one plus 0.08, raise to the 3. Now you have the present value of that one. You do that all the way to year 10. For year 10, it would be your estimated free cash flow year 10. Divide that by 1 plus 0.08 raised

to the 10. Now you have calculated the present value of the estimated free cash flows from year 1 to 10. Now you sum those up. You literally add them. Add present value from year 1, present value of free cash flow year two, present value of free cash flow year three, present value of free cash flow year four, on and on until you get to present value of free cash flow year 10. You add those up and now you have the sum of the present value of the free cash flows for your projection period, year one through year 10. Now, we just use a perpetuity formula to calculate the free cash flows you think the company is going to generate from year 11 until the end of time, using a perpetuity. Okay. How do you do that? You need to come up with a terminal

growth rate. Remember we estimated how fast you thought revenue was going to grow year one, how fast you thought it was going to grow year two, how fast you thought it was going to grow year three and on and on. And I told you to fade that growth rate down by the last year of your forecast period. Your terminal growth rate can't be set higher than global GDP. Why? Because if a company grows faster than global GDP into perpetuity, then that one company will eventually become bigger than global GDP. Right? Doesn't make sense. So you can't set your terminal growth rate faster than, you know, 3%. Pick your number. Three and a half. If you're just valuing a slow-growing domestic U.S. company, you may want to set the terminal growth rate at 2, 2.5%. These are low

growth rates, fools. So you can't have your year 10 growth rate in the last year of your model, 50%. And then all of a sudden, year 11, it's 2%. It doesn't work. You have to fade your growth rate down. So for the terminal value, you have to pick your terminal growth rate. Then you take the free cash flow in the last year of your projection period, that's year 10. You multiply it by 1 plus your terminal growth rate, that's your numerator, and you divide that by R minus G, by your cost of capital, that's R minus your terminal growth rate. So once again, the formula for the terminal value, for the perpetuity, you take the free cash flow in year 10 for your numerator. Your numerator is free cash flow year 10 multiplied by 1 plus your terminal growth rate.

Let's say it's 2%. Divide that and your denominator is your cost of capital, which we said was 8%, minus your terminal growth rate, which we said was 2%. That gives you your terminal value. But that also has to be discounted back to the present. How do you do that? The same exact way discount our free cash flows you take that terminal value number you divide by one plus the growth your terminal growth rate which is two percent raised to the power of ten raised to the the number of years you have in your projection period So, now, we have summed up, we have added up the present values of free cash flow in year 1 through year 10.

We have that sum. To that, we add the present value of the terminal value. you get enterprise value okay you now have a present value of the cup of the estimated enterprise value of that business you then enterprise value means the value of the firm the value to so we calculated the free cash flow that we calculated fools which we which you know we just said was no path in this model minus reinvestment that is something called free cash flow to the firm FCFF that's free cash flow available to debt and equity holders okay so we had just

calculated a firm that not calculated we have just estimated a firm value an enterprise value okay but what are we trying to do we're trying to value the equity and the stock not the firm but we've just calculated the firm value so what do we do we subtract debt we have to pay back all of the debt holders okay Okay, subtract debt. Any cash that is left over, because we have just paid back debt holders. Any cash that is left over after we paid back all our debt now belongs to the equity holders. So we add back cash.

So we have this present value of the terminal value, this firm wide value. We subtract debt and we add cash. Now we have equity value, the value of the equity in that business, but we don't have the value of the stock yet. To do that, you just take the value of the equity that you just estimated, divide by the number of shares outstanding the number of fully diluted shares outstanding and you have now calculated an estimated value per share you take that estimated value per share and you compare it to the current stock price

and if the estimated value per share is higher than the stock price, then maybe you found yourself a bargain. If you think the company is worth $100, that's your estimated value per share, and the stock's only trading at $50, then maybe you found yourself a bargain. Maybe you found yourself a company whose stock is selling at a discount to its intrinsic value. Maybe you have found yourself a stock that offers you a margin of safety. Now, your value that you just estimated is going to be wrong. Because you can't be precise.

You can't be precise. It's going to be wrong. Mine's going to be wrong. Everyone's is going to be wrong. so next step we do some scenario analysis so that we can come up with a range of estimated fair values right just coming up with one precise to the decimal point estimated fair value that's you know not gonna help us much so you we're gonna come up with now a range of estimated fair values and this

is a model it's everything's connected all the cells are connected so you can just go in, change some growth rate assumptions, change some margin assumptions, change the discount rate, hit enter, and the intrinsic value estimate will change instantaneously. So how do you come up with a range of estimated fair values?

One way is to do a bear case, a base case, and a bull case. So your base case is the medium case. It's the case that you think is most likely. The case that you have the highest conviction in. It's the medium case. And you come up with that estimate fair value. And then you do a bear case.

A bear case means you think growth will be slower than in your base case. You think margins will be lower than in your base case. And that gives you a lower estimate of intrinsic value. And then you come up with your bull case, right? Your bear case was, what could go wrong, right? Now you're coming up with your bull case. What could go right?

This one has slightly higher growth assumptions than your base case. Slightly higher margin assumptions than your base case. And this gives you a higher estimated intrinsic value. now fools you've come up with an estimated range of intrinsic values per share for companies that are more predictable like pepsi like a utility like coca-cola your range of estimated fair values is going to be more narrow When you're valuing a crazy startup that's growing 100% a year, has not achieved scale yet, has not proven it can do so, it's much harder to value that company. It's much less predictable.

A company that's growing 100% a year, literally in year 10, you don't know if it's going to be growing 30% or 10%. But PepsiCo, growing 4% next year, I mean, come on. You can feel pretty confident that 10 years from now, it's going to be growing 2% or 3%, right? But a company growing 100%, you don't have a clue. No one does. No one. So your range of estimated fair values has to be much wider. For a company that's not generating profit margins, it's not generating profits, and it's burning through cash, you don't know what its profit margins are going to be in 10 years. You don't really even know if it's going to be profitable in 10 years. That's why you do the work. That's why you do the research. That's why you do the due diligence. And your model,

hopefully, will model out and show you possible paths to profitability. That's the beauty of a model. You hear investors all the time saying, oh, well, it's not profitable, but I see a path to profitability. Show me the path. Show me the model. That's what the model lets you do. It lets you see at least potential paths to profitability and self-funding and free cash flow generation. But for these businesses earlier in their life cycle, they're not yet mature, lots of competition, you're going to come up with a wider range of estimated fair values. Last thing I'll say. What is fair value? We already defined intrinsic value or fundamental value as the present value of future free cash flows. I'm going to give you the exact

same definition just another way. What is fair value? Fair value is the price that you can pay for a stock and earn your discount rate and earn your required rate of return if your model is somewhat correct. That's what fair value is. If you pay fair value for a business, if you think the stock is worth a hundred, that's your estimate of fair value. Okay. That's your base case. You think the stock's worth a hundred and the stock is currently trading at a hundred. it. That's okay. You can still buy that stock. That just means, it doesn't mean you're never going to make a penny. Because why? Because intrinsic values grow over time. If it's a good, if it's a great profitable growth business with a competitive advantage, with an enduring

competitive advantage, intrinsic values grow over time. And so if you pay $100 for a stock that you think is fairly valued at $100, if you pay fair value, that means you should expect to generate an annualized return roughly equal to your discount rate, which we said was 8%. That's a point that gets overlooked all the time. If you're paying fair value, that means you should generate an annualized return over time on average of roughly your discount rate, which we said was 8%. Now, what if you set your discount rate at 5% and you pay $100 for a stock

that you think is fairly valued at 100, well, then if your model is roughly right, then if you buy the stock at 100, you should only expect to earn a rough annualized return of now 5%. Because now we set the discount rate at 5%. And fools, this was discounted cash flow modeling. and I am John Rotonti. Thank you so much for watching.

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. We're off tomorrow for the Easter holiday, but we'll be back on Monday. I'm Dylan Lewis. Thanks for listening. We'll see you soon. Thank you.