Romancing with the DCF Model

If you are an analyst working in an Investment bank, Private Equity, or an Investment firm, you already know what we are talking about. The DCF model.

Maybe you have spent more time with the DCF model than your lovely wife or your children. Jokes apart, DCF does serve as an important tool to come up with the intrinsic value of a company.  

And for the people who have no idea about the DCF model, here’s your chance to learn and fall in love with it. But here’s the deal you have to finish this article till the end. Like any other relationship, completing the journey. No cheating.

Buffet mentioned on intrinsic valuation multiple times through his annual letters, as well as speeches and interviews.

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”  

These thoughts come directly from page 4 of Warren Buffett’s owners manual.

However, many believe that DCF doesn’t help much to value a company as it is totally based on projections about the future. And predicting the future is highly uncertain.

We agree on this to some extent, but definitely DCF does come handy while finding the intrinsic value of a company. DCF is just a tool and it entirely depends upon the analyst how he/she drives it. Consider DCF as a car and analyst as the driver.

DCF issues and solutions:

The entire DCF is dependent on these three variables:

1) Estimates of growth rate in future free cash flow (FCF): This is the rate at which the free cash flow will grow for the next (say) 10 years.

2) Terminal Growth Year: This is the rate used to derive the FCF after 10 years till infinity.

3) Discount Rate: Rate at which FCF would be discounted to get the present value.

Prima facie it looks very simple, however, there are three fundamental issues while assuming these variables:

DCF is simple yet very difficult.

Issues are –

· What growth rate to assume for FCF?

· What should be the terminal growth rate?

· How to assume the discount rate?

Assuming the growth rate for FCF

This is the toughest part of drawing the DCF model, forecasting the FCF numbers for the next 10 years. Even if it is tough or you don’t like forecasting these numbers, you have to do it if you want to be an analyst at a financial services firm. After all, you are paid for that.

Before answering the question, you need to understand that it’s okay to not get a perfect number for FCF. In fact, there’s no perfect number for FCF. It is all based on perception. And people get it wrong. Almost 100% of the time.

We prefer to use a 2 stage DCF where we start by assuming a high growth rate of 10-15% for the first 5 years and for the next 5 years assuming a growth rate of 6-8%. Anything assumed above 15% is too optimistic and not sustainable. We don’t want to daydream, we want to invest right?

So be reasonable, prudent, and use your common sense. The reason for not taking a growth rate higher than 15% is because it increases your downside if things don’t go according to your projections, and vice versa.

These growth rates are not written in any rule book nor are they standard measures for all companies. These are best-used estimates for the majority of companies and asset classes.

The Terminal growth rate?

Businesses are assumed to operate till perpetuity, thus roping in the concept of terminal value.

This value can be calculated using these common methods- Perpetuity Method and Exit Multiple Method.

The terminal growth rate should be as low as 0-2%, anything above 3-4% is like assuming the company will bigger than the economy in the perpetuity. Which is not possible at all.

If a business is highly uncertain or has low certainty that it will generate FCF after 10 years, a terminal growth rate of 0% should be considered. 

Lower the growth rate, higher the margin of safety.

Assuming the discount rate?

In layman terms, the discount rate is the rate at which the future cash flows of the businesses are discounted to present value.

You can also think of this rate to be the expected return you would like to have from your investment.

For e.g. If you want a return of INR 1000 from your investment after a year, what should be the value that you have to pay today?

· Discount rate 8%, you have to pay INR 926 today (1000/1.08)

· Discount rate 10%, you have to pay INR 909 today (1000/1.10)

· Discount rate 15%, you have to pay INR 870 today (1000/1.15)

So higher is the discount rate lower is the amount you have to pay today.

Use a higher discount rate if you are looking to invest in small-cap stocks or startups as the risk is high you would want a higher return.

For established and stable businesses, use a lower discount rate like 10-12% as their returns are less volatile compared to small-cap stocks.

Alternatively, you can take a blanket discount rate of 15% for all the companies and adjust the FCF growth rates case-to-case basis.

What next?

Forgot the margin of safety- it acts as a cushion in the bad times, bad judgment, and bad timing in the markets.

So having a margin of safety acts as a protective layer to your investments.

This is how margin of safety works- If you come up with an intrinsic price of INR 100/share, then considering this number as INR 67 (i.e. 2/3 of the intrinsic value) would give you the cushion if things don’t go well in the market.  

Moreover, the margin of safety can be adjusted according to the comfort level in the stock you are investing in. If you understand the business very well then a lower margin of safety can be considered. However, if you don’t understand the business very well but still want to invest in that stock, then a higher margin of safety could be a lifesaver. 

DCF is a great tool to value companies having the following features-

1) Predictable Free Cash flow generating companies

2) Having sustainable and inherent competitive moats

3) Run by great management with good governance

4) Less likely to be influenced by macro risks

5) Dominant position with high market share

6) Delivering high ROCE and revenue growth for the past 5 years

7) Large barriers to entry

8) Clean accounting

9) Strong balance sheet and doesn’t have to rely on outside capital

 If these above principles are sincerely followed by investors, it’s very difficult to burn money in the long term.

That’s all about DCF for today.

You can refer to this sheet for projecting FCF and calculating the intrinsic value of a company.

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