The DCF calculator has a different approach to valuating a stock when compared to the intrinsic value calculator, which has been presented previously throughout the courses. The DCF calculator uses cash flows for valuation. The calculator typically first calculates for the coming 10 years, and then in addition it estimates the value of the stock if you hold it forever – this is also called perpetuity.
To get the easiest insight into how the calculator works and making it as user friendly as possible, the DCF calculator is broken down into 6 simple steps:
- Estimate the free cash flow
- Estimate the short term growth rate
- Determine the short term
- Determine the discount rate
- Determine the growth into perpetuity
- Input the number of shares outstanding
In the following lesson, a further elaboration of each step is shown. It is important to emphasize that when talking about estimates, estimates are exactly what you get. They are qualified guesses about the future – nothing more and nothing less. This is also why you will see that two people with the same information available will come up with two different numbers for the value of a stock.
1. Estimating the Free Cash Flow (FCF) is the first step in the process and the investor is advised to look back at the 10 previous years to get an indication about the level of FCF the company can expect to make in the future. Remember that FCF is similar to what Warren Buffett calls the owner’s earnings, which is the money that is actually flowing back to you as a shareholder. BuffettsBooks.com has provided you with a tool that allows you to write a ticker, and automatically be taken to a site where you can copy paste the required data. FCF can change a lot from one year to the next dependent on the investment level, so it is important to look back in time.
2. Estimating the short term growth rate can also be approached by an assisting tool similar to the one in step 1. While the past can be used as an indicator, it is very important to consider the growth/maturity state of the company. For very large companies you might only want to use a few percent, while smaller companies typically grow at a much larger pace.
3. Determining the short run is interrelated with step 2. Many companies grow at a rapid pace for only a short period of time until they mature. For example, an IT company might be growing with double digit numbers for 5-10 years, followed by a more modest growth.
4. Determining the discount rate is another way of asking which return you would require from a stock as an investor. While this might seem a bit redundant, it is a measure asking about how you deem the risk of the stock. For a new IT company you might require a larger return than for a large 10+ billion dollar net income company that has been around for over a century. At the final step of the calculation, BuffettsBooks.com has provided you with a simple solution if you want to leave the input at a generic 10% level.
5. Determining the growth rate into perpetuity (forever) might seem like an impossible task. As a rule of thumb you are recommended to use 2-3%, which is simply the estimated inflation. It would be unrealistic to include a high growth rate forever.
6. Input the number of shares outstanding. So far this calculation has been based on numbers for the whole company. This step takes the process down to a per share basis, making it comparable with the present share price of a single stock.
What has happened after all 6 steps is that the intrinsic value of a stock has been calculated for a single stock. This is done by discounting the estimated FCF that you, as a shareholder, would receive for holding the stock.
A few pointers that might be helpful:
- Intrinsic value > market price = opportunity for a good bargain.
- Intrinsic value < market price = risk of overpaying for the stock
Compared to the intrinsic value calculator in lesson 21, this calculator can be recommended to be applied for:
- Valuating high growth companies
- Companies having a large number of share buy-backs
- Companies having stock splits
If you’re interested in a more detailed description with an outline of how this calculator works, it can be found in the “Warren Buffett Accounting Book”. This book was written by us, Preston Pysh and Stig Brodersen, and it contains all formulas and definitions. If you have any specific questions about this calculator, please do not hesitate to ask Preston and Stig directly at our forum.
Free Cash Flow
The free cash flow is often referred to as “owner’s earnings”. A full video explanation of the concept is given in lesson 34.
This concept can best be explained by an example: If a company has 100 stocks and earnings of $100, the EPS would be $1. If 50 stocks were bought back leaving 50 shares outstanding, EPS would be $2 ($100/50).
If a stock price is very high, for example, $300-500, many companies would at some point choose to split their stock to increase the liquidity. That way more people can buy more stock, but the value of your holding is the same. For example, if you owned a stock at $300, after a 2-1 stock split you would own 2 stocks both priced at $150.
In Lesson 7, you learned what the owner’s earnings were. Now, you will learn how to discount a cash flow over the life cycle of the actual stock that you are potentially buying.
Scroll down the Buffett’s Books website to see another intrinsic value calculator. It’s a bit different from course 2 where you used a dividend to estimate future cash flows over a 10-year period. This calculator steps further. It not only values the cash flow in the next 10 years, but forever.
At the very first line is the question “What is your company’s free cash flow?” The starting point for assessing the value is to estimate the free cash flow. Unlike course 2, this course values the entire business as a whole. After finding the free cash flow, divide it by the total number of shares outstanding to get the per share intrinsic value. In course 2, you were already working at a per share level.
How do you estimate the future cash flow? On the right hand side of the video that’s highlighted in blue, click “Estimate average cash flow.” A little window on top will say “Please input value for historical free cash flow to determine the average.” Go back and determine what the owner’s earnings have been over the past 10 years to develop an average for what the current free cash flow of the business is.
You will find a useful tool that will help you search for any ticker you want in the website. For example, if you want to search Walmart, type the ticker and the browser then opens a new window that brings you to Walmart’s page in Morningstar. You’ll see 10 years’ worth of history for all different data points.
Morningstar is better than MSN because it lays out the past 10 years of data in a way that’s easy to understand. It also automatically calculates the free cash flow. We’ll take the free cash flow for the entire business and input that in the intrinsic value calculator in the website. Highlight the free cash flow for the last ten years and press Ctrl+C. Now, make sure you don’t highlight the last column, because those are the 11th. Copy those and go back to where the discounted cash flow model is at and then hit Ctrl+V. The numbers will automatically populate and calculate the ten years. It’s very quick and easy.
The numbers are in millions, by the way. Walmart had $5.6B of free cash flow to start with until the latest, which is $12B. The free cash flow changes every year for many companies because they might have a lot of capital expenditures in one year, but not in the next. The average for Walmart’s last 10 years is around $8B for the entire company. Click the button that says “Use this average FCF” to automatically update the number in the input box. The free cash flow is the foundation.
Now, estimate how much it’ll grow in the future based off of how many years you want to put in there. Discount those back at today’s value. How much do you think the free cash flow will grow over the next 10 years? If you want to be conservative, you can put 3%. By doing that, you’re essentially saying that Walmart won’t grow at all, but just keep up at inflation; or you can put a higher number like 5, 7, or 10%.
Another tool on the left side estimates an average growth rate. A new window will pop out to help you estimate. If you remember, the free cash flow doesn’t represent a stable number because the company has a lot of capital expenditures; however, we use the net income or book value that might be more represented on how a company might grow over the next 10 years. Walmart’s net income was $9B 10 years ago, and it’s really showing a lot of stability through the years. Now it’s close to 17B in 2013. On and average, let’s say that it went up to 9 billion to 17B over 10 years.
Go back to the estimator. It questions, “What was the net income in the past 10 years?” Write 9B by putting 9000, because we’re dropping the zeros. The current in 2013 went to approximately 17B. The results show it’s grown at about 7% annually. If you believe that the owner’s earnings will grow that much over the next 10 years, click “Use this average growth rate” It will update the information in the input tab to 7.32%.
The next input is, “What do you consider short-term?” That’s how long you will apply the growth rate. If you put in 10 years, assume that the free cash flow of 8B will grow at 7.32% over the next 10 years. After that, we’ll use a different growth rate beyond 10 so that it’s much more conservative. Just use 10 for demo purposes and click continue.
The owner’s earnings are growing by 7.32% each and every year for 10 years and into the future. The free cash flow would be around $16B, and it’s currently at $8B now.
The next question is, “What discount rate do you want to use to discount these future cash flows?” This is important to understand. For example, if it’s $50 a share with a discount rate of 10%, the company is actually trading on the stock market for $50. You can generally assume that you made 10% annual return based off of that discount rate input. If the intrinsic value isn’t $50, you need to manipulate the discount rate until the market price and intrinsic value are equal. The discount rate will tell what the expected annual return is. Right now, use a generic 10%. Click on continue. You’ve taken the future cash flows and discounted them back to today’s value at a 10% rate for each year during the next 10 years.
Let’s get on to the next step now. The value is $17B over 10 years. First, make sure to use a very conservative number. Don’t go higher than the estimated inflation rate. For now, it is 3%. It’ll add up all those cash flows and then discount it back to today’s value. Hit continue. Now, the discounted perpetuity cash flow for the first 10 years is $70.8B discounted back to today’s value. When you add in the discount of perpetuity value, it’s another $90B. The calculator has simply done everything for you. You may do it by hand. Everything is in The Warren Buffett Accounting Book. It has all the calculations if you really want to understand it.
Lastly, find out how many shares outstanding are in the company. Divide the cash flow to get the intrinsic value per share by first going back to Morningstar. Click “Quote” and it’ll bring up Walmart’s quote. Below, it says “Shares outstanding” is at $32.2B. Remember, you dropped the zeroes off. Copy that number and paste it into the field. Click on continue to figure the intrinsic value based off of all those inputs. Right now, the intrinsic value per share is $49.22 at a 10% annual discount rate.
What is Walmart currently trading for? $75.2. However, that’s not what the intrinsic value is saying. It is at $49. What kind of return would you get now at $75.2?
The final step doesn’t force you to go through a trial and error. Just input the last field that says, “How much is your company trading for on the stock exchange”? Enter $75.2. Hit calculate. Based on the cash flows you have forecasted and a market price of $75.2, this company may yield a 7.76% annual return.
One thing that’s nice is that if you want go back and adjust 10 years, you need to just type in the year you want and hit calculate. The chart updates for the future 5 years of that 7.32% and it immediately goes to the perpetuity growth at 3% and recalculates the numbers. You can see how the intrinsic value got worse because the free cash flow was not growing at such a long rate of 7% for 10 years.
Let’s say you were valuing Apple three years ago when they were extremely growing at an enormous growth rate of 25%. You’d only anticipated that lasting for a couple more years. Put in 3 years and a high growth rate, but also keep a really low growth rate for after those 3 years for that perpetuity growth rate. Hit calculate. It grew for another couple of years and it’ll level that out. You’ll get a much more symbolic representation of what a future cash flow might be like with Apple or some type of emerging or growth pick.
What are the benefits and advantages of this calculator? If you have a company that has a very high amount of share buy backs. A perfect example is IBM.
In the past 5 years, IBM has been buying back a lot of their stocks at an enormous rate. When that happens from an accounting standpoint – when they were using their own cash on hand to repurchase outstanding shares – those will be listed as the treasury stock in the equity line of the balance sheet. Even though they have large amount cash flows, the book value growth won’t grow because of accounting tricks that’s been occurring. You’d have a harder time finding out the value without using a calculator like this one.
Lastly, DFC models work better if a company’s previous performance had stock splits.