BUFFETTS BOOKS ACADEMY: ADVANCED COURSE

LESSON 35: INTRINSIC VALUE CALCULATOR – THE DISCOUNT CASH FLOW MODEL

LESSON 34
COURSE OUTLINE
ACADEMY

THE DCF CALCULATOR


What is your company's free cash flow (Owners Earnings)?
Estimate average free cash flow?
Please enter valid positive cash flow value.
In the short term, what percent annually (use a whole number) do you expect the free cash flow to grow?
Estimate average growth rate?
Please enter valid positive percentage value.
What do you consider short term (most common is 10 years)?
Please enter short term (use whole number) from 1 to 10.
TEACH ME!

LESSON SUMMARY

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:

  1. Estimate the free cash flow
  2. Estimate the short term growth rate
  3. Determine the short term
  4. Determine the discount rate
  5. Determine the growth into perpetuity
  6. 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:

  1. Valuating high growth companies
  2. Companies having a large number of share buy-backs
  3. 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.

Related Article: DCF Intrinsic Value Calculator

NEW VOCABULARY

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.

Share Buy-Back
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).

Stock-Splits
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.

LESSON TRANSCRIPT

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.