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.
Related Article: DCF Intrinsic Value Calculator