If you've ever thumbed through a stock analyst's report, you will have probably come across a stock valuation technique called discounted cash flow analysis, or DCF for short. DCF entails forecasting future company cash flows, applying a discount rate according to the company's risk and coming up with a precise valuation or "target price" for the stock.
The trouble is that the job of predicting future cash flows requires a healthy dose of guesswork. However, there is a way to get around this problem. By working backward - starting with the current share price - we can figure out how much cash flow the company would be expected to make to generate its current valuation. Depending on the plausibility of the cash flows, we can decide whether the stock is worth its going price.
DCF Sets Target Prices
There are basically two ways of valuing a stock. The first, "relative valuation," involves comparing a company with others in the same business area, often using a price ratio such as price/earnings, price/sales, price/book value and so on. It is a good approach for helping analysts decide whether a stock is cheaper or more expensive than its peers. However, it's a less reliable method of determining what the stock is really worth on its own.
As a consequence, many analysts prefer the second approach, DCF analysis, which is supposed to deliver an "absolute valuation" or bona fide price on the stock. The approach involves explaining how much free cash flow the company will produce for investors over, say, the next 10 years, and then calculating how much investors should pay for that stream of free cash flows based on an appropriate discount rate. Depending on whether it is above or below the stock's current market price, the DCF-produced target price tells investors whether the stock is currently overvalued or undervalued.
In theory, DCF sounds great, but like ratio analysis, it has its fair share of challenges for analysts. Among the challenges is the tricky task of coming up with a discount rate, which depends on a risk-free interest rate, the company's cost of capital and the risk its stock faces.
But an even bigger problem is forecasting reliable future free cash flows. While trying to predict next year's numbers can be hard enough, modeling precise results over a decade is next to impossible. No matter how much analysis you do, the process usually involves as much guesswork as science. What's more, even a small, unexpected event can alter cash flows and make your target price obsolete.
Discounted cash flow, however, can be put to use in another way that gets around the tricky problem of accurately estimating future cash flows. Rather than starting your analysis with an unknown, a company's future cash flows, and trying to arrive at a target stock valuation, start instead with what you do know with certainty about the stock: its current market valuation. By working backward, or reverse-engineering the DCF from its stock price, we can work out the amount of cash that the company will have to produce to justify that price.
If the current price assumes more cash flows than what the company can realistically produce, then we can conclude that the stock is overvalued. If the opposite is the case, and the market's expectations fall short of what the company can deliver, then we should conclude that it's undervalued.
Here's a very simple example of how to think through a reverse-engineered DCF. Consider a company that sells widgets. We know for certain that its stock is at $14 per share and, with a total share count of 100 million, the company has a market capitalization of $1.4 billion. It has no debt, and we assume that its cost of equity is 12%. This year the company delivered $5 million in free cash flow.
What we don't know is how much the company's free cash flow will have to grow year after year for 10 years to justify its $14 share price. To answer the question, let's employ a simple 10-year DCF forecast model that assumes the company can sustain a long-term annual cash flow growth rate (also known as the terminal growth rate) of 3.0% after 10 years of more rapid growth. Of course, you can create multi-stage models that incorporate varying growth rates through the 10-year period, but for the purpose of keeping things simple, let's stick to a single stage model.
Instead of setting up the DCF calculations yourself, spreadsheets that only require the inputs are usually already available. So using a DCF spreadsheet, we can reverse-engineer the necessary growth back to the share price. Lots of websites provide a free DCF template that you can download, such as office.microsoft.com and www.stockodo.com.
Take the inputs that are already known: $5 million in initial free cash flow, 100 million shares, 3% terminal growth rate, 12% discount rate (assumed) and plug the appropriate numbers into the spreadsheet. After entering the inputs, the goal is to change the growth rate percentage in years 1-5 and 6-10 that will give you an intrinsic value per share (IV/share) of approximately $14. After a bit of trial and error, we come up with a 50% growth rate for the next 10 years, which results in a $14 share price. In other words, pricing the stock at $14 per share, the market is expecting that the company will be able to grow its free cash flow by about 50% per year for the next 10 years.
The next step is to apply your own knowledge and intuition to judge whether 50% growth performance is reasonable to expect. Looking at the company's past performance, does that growth rate make sense? Can we expect a widget company to more than double its free cash flow output every two years? Will the market be big enough to support that level of growth? Based on what you know about the company and its market, does that growth rate seem too high, too low or just about right? The trick is to consider as many different plausible conditions and scenarios until you can say with confidence whether the market's expectations are correct and whether you should invest in it.
The Bottom Line
Reverse-engineered DCF doesn't eliminate all the problems of DCF, but it sure helps. Instead of hoping that our free cash flow projections are correct and struggling to come up with a precise value for the stock, we can work backward using information that we already know to make a general judgment about the stock's value.
Of course, the technique doesn't completely free us from the job of estimating cash flows. To assess the market's expectations, you still need to have a good sense of what conditions are required for the company to deliver them. That said, it is a much easier task to judge the plausibility of a set of forecasts rather than having to come up with them your own.