## Wednesday, September 14, 2011

### How to Value Stocks Using DCF

#### Valuing a Stock with the DCF Method

You may have found a great company that you feel has outstanding potential but always end up getting stuck at what price you should purchase the company. Finding the value of a stock is a critical part of investing successfully. Valuing stocks is not hard, but it does require logic and practice.

Calculating stock values surprising should not consist of lengthy and complicated formulas. If you understand the concepts of how to go about thinking through a stock valuation, you will understand that you don't need to understand the derivation of the formula to apply it well and to achieve profits off your investments.
Let me give you an example.
The real formula to perform a discounted cash flow is:
DCF = CF0 x SUM[(1 + g)/(1 + r)]n (for x = 0 to n)
Now this formula will excite a few, but for the rest, my advice is to just understand what a DCF calculation is and what variables you need to include and adjust.

#### DCF Discount Rate

The purpose of a discounted cash flow is to find the sum of the future cash flow of the business and discount it back to the present value. To do this you need to decide upon a discount rate.
Simply put, a discount rate is another phrase for "rate of return". i.e. what is your return requirement for this investment to be worth the risk?

You wouldn't expect a return of 3% off your stock investment because you could easily get that from a Certificate of Deposit (CD) or even just your normal bank account. A treasury bond will probably give you a better return.

If the bank and fed are risk free investments at 3%, then why bother using 3% as a discount rate?
So what would be a good rate?

Considering that the "average" market return is about 9-10%, a minimum discount rate should be set to 9%. I use 9% as a minimum for stable and predictable companies such as KO while 15% is a good return for less predictable companies such as NTRI.

A somewhat more difficult and confusing definition of discount rate would be, how much emphasis you place on the future cash in terms of today's dollars rather than the future dollars.
E.g. What price would you pay for an investment today if company XYZ future cash flow is worth \$100 after 1 year?

Discount Rate: 5% = 100/1.05 = \$95.24
Discount Rate: 10% = 100/1.1 = \$90.90
Discount Rate: 15% = 100/1.15 = \$86.96
Discount Rate: 30% = 100/1.3 = \$76.92

As you can see the higher the discount rate, the cheaper you have to purchase the stock because your required rate of return is much higher. This means that since you are willing to pay less now, you are placing more emphasis on the current cash flows of the company.

#### DCF Growth Rate

Growth rate is going to be the Achilles heel to any stock calculation. By growth rate, I mean the FCF growth rate.

I prefer to value stocks based on the present data rather than what will happen in the future. Anything could happen even in 1 year, and if the growth rate is too high and the company cannot meet those expectations, there is no where to go but down.

The best practice is to keep growth rates as low as possible. If the company looks to be undervalued with 0% growth rate, you have more upside than downside. The higher you set the growth rate, the higher you set up the downside potential.

Look at what happened to SPWR and FSLR. Solar energy was the rage in 2008 and growth was estimated to be at 50% and above, but these lofty expectations only make the fall harder.
Growth rates doesn't have to be accurate. Just be reasonable and use common sense.
On most of the stocks I value, I rarely go above 20%, and that's only for something like AAPL.

What I failed to do in the beginning when I started valuing stocks was to adjust the FCF numbers for cycles and one time events.
If you start a discounted cash flow calculation based on either a year with higher than normal FCF or much lower FCF, as is the case in 2008, the stock calculation will also be wrong.
Be sure to consider taking the median or average for the past few years to determine the normalized free cash flow.
The point of the stock valuation is to be realistic, not pessimistic or optimistic.

#### Margin of Safety

Whatever rate you choose, never, never forget to apply a margin of safety. This is the equivalent of a kill switch on the treadmill. It's there to prevent you from getting hurt.

An important point is to not confuse a high discount rate for a margin of safety.
For lower discount rates it is advised that you use at least 50% margin of safety while for discount rates of 15%, a 25% margin of safety may be adequate.

This is because since you are requiring a higher return immediately off your investment, you are trying to pay much less than a discount rate of 9%. So by placing more emphasis on a higher return, you are in fact reducing the risk of the investment which is why a 25% margin of safety may be enough.

#### Summary

• A discount rate is your rate of return. Higher discount rate means you are trying to pay less for the future cash flows at the present time.
• Growth rates are the fuzziest aspect of valuing stocks and should be applied conservatively.
• Adjust numbers to remove one time events and cycles. Always consider a normal operating environment.
• Never for a big margin of safety. The best of us get it wrong as well.
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