Fair Value: Discounted Cash Flow

Timing an investment decision in a company is challenging. Common valuation multiples, such as Price-to-Earnings (P/E), Price-to-Sales (P/S), and Price-to-Book Value (P/B) (see more details here) can serve as rough indicators of whether a stock is expensive or cheap. However, investors and analysts can gain better insights by estimating a company's fair value based on their own projections and assumptions.

This is where the Discounted Cash Flow (DCF) model becomes valuable. Used as far back as the 18th and 19th centuries, this method has been a cornerstone of investment analysis. Famous investors like Benjamin Graham and Carl Icahn have relied on DCF to guide their decisions.

At its core, the DCF model forecasts a company's free cash flows (FCF) and discounts them to their present value, much like how bond valuation involves discounting future coupon payments and principal. While the DCF method provides a logical and structured framework, its accuracy depends heavily on the quality of its assumptions and inputs.

In theory, a company's intrinsic value equals the present value of all future free cash flows, plus the market value of its assets and intangibles, including goodwill.

We begin by examining net income and earnings per share (EPS) as the foundation of cash flow analysis. Next, we explore changes in net working capital (NWC) - including shifts in receivables, payables, and inventory - and how these impact liquidity. We then adjust reported earnings by accounting for non-cash expenses like depreciation and amortization to reflect actual cash flow.

Once these components are established, we derive free cash flow (FCF), representing the cash available for reinvestment or distribution. Finally, we introduce the weighted average cost of capital (WACC) as the discount rate, which helps determine the present value of future cash flows and, ultimately, the company's fair value.

To estimate a company's discounted cash flow (DCF), we begin by analyzing its income statement. The first step is calculating gross profit, which is derived by subtracting the cost of revenue, also known as the cost of goods sold (COGS), from the company's total sales.

For well-established and mature companies, it is common to analyze historical data from the past 4–5 years, using the income statement, balance sheet, and cash flow statement as references. This historical data helps create a reliable foundation for projecting future performance.

Next, we determine the company's operating profit, also known as earnings before interest and taxes (EBIT). This is calculated by subtracting selling, general, and administrative expenses (SG&A), depreciation, and other operating expenses from gross profit.

With EBIT calculated, we then deduct interest expense and adjust for any non-operating income (or expense) to determine the company's pre-tax income:

Finally, we subtract taxes paid from pre-tax income to arrive at net income, the company's final bottom-line earnings:

From net income, we can calculate earnings per share (EPS) by dividing net income by the average shares outstanding:

Next, we forecast the company's growth. If we assume that future revenue growth will follow the historical average revenue growth rate, we apply this rate to the most recent revenue figure to project sales for the upcoming years.

For each forecasted year, we estimate the cost of goods sold (COGS) and selling, general, and administrative expenses (SG&A) by multiplying the projected revenue by their respective historical ratios.

For interest expenses, other non-operating income (or expense), and average shares outstanding, we typically assume they remain constant at their most recent levels unless there is a strong reason to adjust them.

Changes in net working capital (NWC) affect free cash flow (FCF) because they reflect shifts in a company's short-term operational liquidity, which are not captured in the income statement.

To calculate NWC, we extract the total current assets and total current liabilities from the balance sheet.

For the final components of free cash flow (FCF), we need to project depreciation & amortization and capital expenditures (CAPEX).

Now that we have projected values from the income statement, balance sheet, and cash flow statement, we can calculate the weighted average cost of capital (WACC) and the free cash flow to the firm (FCFF).

Weighted Average Cost of Capital (WACC)

The WACC represents a company's overall cost of capital, incorporating both equity and debt financing. Since stocks are inherently volatile, investors demand a risk premium above the risk-free rate (typically based on the 10-year U.S. Treasury yield) for taking on equity risk.

Free Cash Flow to the Firm (FCFF)

With WACC calculated, we use it to calculate the discounted present value of the free cash flow. The Free Cash Flow, as a reminder:

Before moving forward, we need to establish the terminal growth rate (g), the constant rate at which a company's free cash flow (FCF) is expected to grow indefinitely beyond the final year (T) of the forecast period. A reasonable assumption for long-term sustainable growth is typically around 3-5%, though this can vary based on the industry and economic conditions.

Once we have the terminal growth rate, we estimate the terminal value (TV), which represents the value of all future cash flows beyond the explicit forecast period. This is calculated using the perpetuity growth formula:

To determine the company's enterprise value (EV), we discount each year's FCFF and the terminal value back to the present using the WACC as the discount rate.

Where T = Final year of the forecast period, and Σ = Summation of discounted cash flows.

Once we have the enterprise value, we calculate the equity value, which represents the value available to shareholders.

Given that Equity Value = Number of Shares Outstanding × Share Price, once we have the total equity value estimation, we calculate the intrinsic stock price by dividing it by the total number of shares outstanding:

This valuation approach helps investors make informed decisions based on their conviction in the company's future growth and cash flow projections. The DCF model serves as a fundamental anchor for investment analysis, providing a systematic framework for estimating intrinsic value based on business fundamentals rather than market sentiment.