How to Value

Stocks: Part 1
Discounted Cash Flow

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Introduction

The key to buying low and selling high is identifying the intrinsic value of a
potential investment. “It’s the only logical approach to evaluating the relative
attractiveness of investments and businesses.”

“Intrinsic value can be defined as simply: It is the discounted value of the cash
that can be taken out of a business during its remaining life.” (Warren Buffett)

Note that Buffett states the “value of the cash”, not “earnings” or “net income”.
That’s because a company’s reported income often doesn’t paint the whole
picture. It doesn’t include the company’s capital expenditures, like buying new
equipment or investing in new facilities.

A company could be posting positive net income for the past 10 years, but
because of its capital expenditures, it could actually be losing money. This loss
will only be reflected in the company’s free cash flow.

In this series, we’re going to highlight a couple different approaches to calculating

the present value of a company’s future free cash flow. For this installment, we’ll
focus on how to do a discounted cash flow valuation. It’s the present value of the
future free cash flow of the business plus its equity.

It’s simpler to do than you’re probably expecting. It just requires some basic math
and there are tools that can help you, but we’ll get to those later.

Discounted Cash Flow

To do this approach, you need 10 years of financial statements. Locating 10

years of financial statements for free is somewhat difficult. But, there are a
couple sources:

Vuru - At the bottom of each stock analysis, you can export up to 10 years of
Cash Flows, Income Statements and Balance Sheets. We also calculate FCF for
you.

ADVFN.com - Not very user-friendly, but if the company’s existed for 10 years,
they’ll have the financial data. They also calculate Free Cash Flow (FCF) for you.

Once you have 10 years of Free Cash Flow numbers, we can start.

To calculate a stock’s intrinsic value using a DCF, there are four main questions:

1. How much has Free Cash Flow Grown During the Last 10 Years?
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To figure this out, we have to calculate the compound average growth rate
(CAGR) for several time periods over the past 10 years. It’s a pretty simple
calculation.

Let’s say the most recent data we have is 2010. We’ll call that Year 10. 2001 will
be Year 1. Here are the time periods we need to calculate their CAGR:

Year 1 to Year 8
Yr 2 to Yr 9
Yr 3 to Yr 10
Yr 1 to Yr 6
Yr 3 to Yr 8
Yr 4 to Yr 9
Yr 5 to Yr 10

To calculate the CAGR for each time period, the formula is:

(Yr 8 / Yr 1) (1/ # of years between Yr 8 and Yr 1) - 1

For example, if Yr 8’s Free Cash Flow was $1,000 and Yr 1’s FCF was $500, the
calculation would look like this:

(1000/500)(1/7) - 1 = 0.104

That gives us a CAGR of 10.4% from Year 1 to Year 8.

Calculate the CAGR for each of the time periods above. If either the first or last
year of the time period is negative, make the CAGR 0% for that time period.

Take the average of the two median CAGRs. We’ll use this number as a base to
project the company’s future free cash flow.

2. How will the Company Perform in the Future?

This is a difficult question to answer. That’s why it’s vital to be conservative in

your estimate of future growth, since growth generally fades over time. “A recent
article in the Financial Analysts Journal confirmed...that the fastest-growing
companies tend to overheat and flame out.” (pg. 305 of The Intelligent Investor
by Benjamin Graham)

We recommend capping the growth rate you calculated above for that very
reason.

At Vuru, the growth rate we use is capped at 11.25% and we slow it down as the
years pass, as it’s likely that growth will slow over the years, as stated above.
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We’ve chosen 11.25% for two reasons. First, statistics have shown that a rate of
growth above 15% “is all but certain to fade, just like an experienced marathoner
who tries to run the whole race as if it were a 100-meter dash.” (pg. 305,
Intelligent Investor) Second, we like having a healthy margin of safety on our
investments. Using a conservative growth rate decreases the intrinsic value,
meaning that we have more room for error because stocks have to be that much
more undervalued for us to consider them a prospective investment.

Arm yourself with your conservative growth rate and let’s dive into the math:

Future Free Cash Flow (FFCF) for 2011 = Yr 10’s Free Cash Flow * Growth Rate

You can apply this formula for the next 9 years, but we’d recommend being even
more conservative by slowing the growth rate through the years as we do.

The formulae would like this, if you assume Yr 10’s FCF is $1,000 and our
growth rate is 11.25%.

FFCF for 2011 = 1,000 * (1 + 0.1125)

2012 = FFCF for 2011 * (1 + 0.1125)
2013 = 2012 * (1+ 0.1125)
2014 = 2013 * (1+ (0.1125* 0.9))
2015 = 2014 * (1+ (0.1125* 0.9))
2016 = 2015 * (1+ (0.1125 * 0.9))
2017 = 2016 * (1+ (0.1125 * 0.9 * 0.9))
2018 = 2017 * (1+ (0.1125 * 0.9 * 0.9))
2019 = 2018 * (1+ (0.1125 * 0.9 * 0.9))
2020 = 2019 * (1+ (0.1125 * 0.9 * 0.9))

Next, take the 2020 Future Free Cash Flow number and apply a terminal growth
rate of 3%. The terminal growth rate is the rate of interest we can expect the
company’s cash to generate. The formula would look like this:

FFCF 2021 = 2020 * (1+0.03)

You need to do this for years 2021 to 2030.

We need to now figure out the present value of this future money.

3. What Rate of Return Do You Require?

What are you willing to pay today for that free cash flow in the future?

For instance, if that future free cash flow totals $115,000, what is the most you
would pay right now to receive that money one year in the future? $100,000?
$105,000?
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When making this decision, you need to consider all of the work and risk
involved. Consider the amount of time you’ll have to put in to get that $115,000,
that includes research and checking up on your company. What kind of return
would you have to achieve to make that worthwhile?

Also, keep in mind that that there are risks in investing in a single stock and
those need to be accounted for properly. Your desired rate of return should
probably be above what the stock market has returned on average over the past
100 years, 8-10% (Source).

At Vuru, we would pay $100,000 to gain $115,000 one year from now, because
our goal is to earn 15% on average for the long term. This rate of return would
double our money approximately every 5 years. That hits our risk/reward ratio
sweet spot because:

“The stock market has returned on average 8-10% per year for the
past 100 years (Source).

Thus, to take on the risk of investing in a single security, we would

need more than a 10% annual return. Otherwise, we could simply
purchase a S&P 500 ETF, which would produce the same results
with less risk.

When investing in a single security, its risk needs to be accounted

for. While we acknowledge that discount rates may vary due to
industry level risk, we've determined that we would need to see
annual returns of at least 15% to make these risks worth taking.”
- Vuru FAQ in the ‘Statistics and Calculations’ section

Divide your answer of how much you’d pay for $115,000 in free cash flow one
year from now, by $115,000, and you’ll have your desired rate of return. This
number is also known as a discount rate, so we’ll be using it to determine the
present value of stocks’ future free cash flow (FCF).

Only a couple more steps and we’re done, so let’s dive back into the math:

To determine the present value of the future FCF, you need to discount each
year of future FCF individually. Formula:

Present Value of a Single Yr’s Future FCF = Single Yr’s FFCF * (1 – Discount Rate)
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For instance, 2011’s Future FCF, from our example above, is $1,112.50 but its
value to us today is $945.63, based on a 15% discount rate. The formula would
look like this:

Present Value of 2011 FFCF = $1,112.50 * (1 - 0.15)

Do this for each year 2011 to 2030 and then add it all up. That’s the Net Present
Value of all the future free cash flow for that particular stock. One more step and
you’re done.

4. How much equity does the Company have on the Balance Sheet?

This is pretty simple. Look on the Balance Sheet for the most recent quarterly
data on Shareholders’ Equity or Stockholders’ Equity. It’ll be one or the other.

Grab that and let’s calculate this stocks’ Intrinsic Value:

Intrinsic Value = Net Present Value of Future FCF + Shareholders’ Equity

To get a per share value, divide the intrinsic value by the number of Shares
Outstanding. You can find this number on Google Finance, or any general stock
website.

Compare the intrinsic value to the stocks’ current price to determine if its
undervalued and by how much.

We’re done! Congratulations, you now know one of the ways to calculate the
intrinsic value of a stock!

Calculating the intrinsic value of each company is time consuming. This the
problem that we strive to solve at Vuru. In the time it takes to load your page, our
solution performs this exact calculation for any stock you search and interprets
the numbers into easy-to-understand, qualitative statements to give an overall
picture of the company’s fundamentals.

It was created to eliminate hours of tedious analysis by decreasing the time it

takes to find high quality investments, from hours to seconds.

For more like this, check out our blog and follow us on Twitter: @VuruDotCo.