Discounted Cash Flow Rationale
Discounted cash flow (DCF) analysis is the most popular method of business valuation. It is taught extensively in most finance classes. The goal is to find a reasonable price for a future stream of cash flows and compare it to a risk-free rate of return, usually US treasuries.
It’s also fraught with peril because it usually results in overvaluing businesses. It is the preferred method of valuation in investment banking. I suspect this is because investment bankers can easily game the numbers and make companies appear more valuable than they actually are. Allow me to explain.
Apple Valuation (AAPL)
To show the power of assumptions, let’s try a real world valuation example. Let go with Apple (AAPL) using this method.
Free Cash Flow
Let’s start with a fact: in the 2016 fiscal year, Apple’s free cash flow was: $65.844 billion in operating cash flow – $13.548 billion in capital expenditures = $52.296 billion in free cash flow
At the end of the 2016 fiscal year, there were 5.336 billion shares of Apple common stock.
$52.296/5.336 = $9.80 of free cash flow per share of Apple stock.
So what’s the value of $9.80 in discounted cash flow? Let’s use DCF analysis to figure it out.
Zero Growth Example
For example 1, let’s take an extreme approach. Let’s say Apple won’t grow at all (unlikely). For the interest rate, we’ll use US treasuries. The 10-year US treasury currently pays 2.38%. Here is a link with a detailed explanation of the math.
If you want to do this quickly, Gurufocus has a calculator tool that you can use here. Another nice shortcut is a formula that can be used in Microsoft Excel or in Google sheets. Simply input the following formula into a cell:
=NPV(discount rate, cash flow 1, cash flow 2, etc.)
Now, let’s try to find the present value of a $9.80 stream of cash flows. Based on no growth and 10 years of cash flows and using the 2.38% rate, we get a value for Apple of $86.30.
Growth and Different Discount Rates
2% Growth, 2.38% rate, 10 years = $96.02
What if instead of using the 10 year treasury as our base, we used the 10 year average AAA corporate bond yield, 2.96%
2% Growth, 2.96% rate, 10 years = $93.11
Most likely, Apple isn’t going to go out of business in 10 years. For this reason, most DCF analysis adds a terminal value to the value after the 10 years of cash flows. Let’s proceed with our assumption that there will be 2% growth for 10 years, then let’s say after 10 years the growth rate drops to 1%.
Present value of 10 years of cash flows + Terminal Value = $173.52
Now, what if we increased our assumptions? Let’s say Apple grows by 5% a year, and then the terminal value grows earnings at 3% into the future? Now the value goes up to $228.54!
With DCF analysis, you can make the data say whatever you want. That’s great for investment bankers but it’s not very good for investors.
By messing around with different assumptions, I produced valuations for Apple that ranged from $86.30 to $228.54. All of these assumptions are debatable. You can’t say with any degree of certainty where interest rates are going, what Apple’s cost of capital will be, what their growth rate will be, how long the business will be viable, etc. All of these are assumptions. Also keep in mind that I produced this wide range of values with one of the the largest and most recognizable company in the United States. If we can’t safely value Apple, how can we safely value a micro-cap stock?
For this reason, I avoid discounted cash flow analysis. It is simply too easy to twist around the data with your assumptions and get the result you want. If you want to find a margin of safety with DCF analysis, you’re going to find one. I suspect that this is what the investment banking community does when they want to convince corporate managers to make acquisitions that may not be in the best interests of the acquirer.
A simple ratio (i.e., the stock trades at 10 times earnings) is a far more simplistic . . . and far more telling . . . statistic than DCF analysis. The cheapness of something should hit you over the head and should be abundantly obvious. If it’s not, move onto something else. There are plenty of publicly traded companies. Torturing the data to get the result you want is not a prudent path.
I prefer the Graham approach and focus on what’s actually known in the here and now without making so many assumptions about the future. This is why the Grahamian balance sheet approach (because what’s more clear cut than the value of a balance sheet?) of net-net’s is a nearly foolproof method of investment.
For the goal of finding the present value of cash flows in analysis of stocks, I think a more useful metric is one that is more simple: price to free cash flow or enterprise value to free cash flow. If you can find a decent company like Apple trading at a price to free cash flow of 10 or less, then DCF analysis would likely yield a number close to the current price even with very conservative assumptions. It is probably then a good candidate worthy further research.
In the world of finance, there is a tendency to make things more complicated than they really are. I like to keep things simple.
PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures. Full disclosure: my current holdings.