5 Easy Steps To Calculate Intrinsic Value Using DCF Model
One of the most commonly used ways to find out the intrinsic value of a stock that you want to invest in is to use the Discounted Cash Flow Model. But before you do this method, it is important to first understand the principle of discounting.
So what is discounting by the way? Let me explain this in the easiest way I could.
Suppose you want to buy something of value like gold or a parcel of land. If you’re an investor, the reason you buy these investments is because someday in the next couple of years, you believe that it will be worth more than the price that you paid for it.
If you think a gold coin is worth 10,000 pesos next year, you would buy it for 9,000 pesos today so that you can sell it for 10,000 pesos next year for a 1,000 peso profit or 10% profit.
The 10% rate in this scenario is what we call the discount rate which is defined as the rate you demand for getting your money in the future instead of today. It can also be called the rate of return.
The formula for the discount rate is this;
Discount Rate = Risk-Free Rate + Risk Premium
Risk free interest rate in layman’s term is the rate we use for risk free investments such as retail treasury bonds.
The risk premium is the variable rate we assume that the stock will likely gain in the future. Take note that since stocks are high risk investments, we take on this risk and assume that we may or may not get this rate of return in the future.
So if the gov’t bond rate today is 4% and assuming a risk premium that we believe that the stock will gain next year as 6%, then the discount rate in this case is 10% as the formula suggests;
Discount Rate = 4% + 6% = 10%
So how do we get the present value (PV) of a certain investment? Here’s the formula;
PV = FV/(1+r)^n
- PV = present value of the stock
- FV = future value of the stock at period n
- r = discount rate
- n = period
Now let’s try to apply this to the example below.
Let’s say there’s a certain investment that we believe that will be worth 100 pesos in the next three years. Assuming a discount rate of 11%, the present value of that investment would be;
PV = 100 / [(1+0.11)^3]
PV = 73.12 Php
In this example, we believe that the investment is worth 100 pesos in the next 3 years, so we buy it today at 73.12 pesos taking the risk that it may or may not reach the desired amount of 100 pesos in 3 years.
In other words, 73.12 pesos is the amount that we are willing to pay today to receive 100 pesos after 3 years.
That's the concept of discounting.
Now, the question is how do we use this to find stocks that are undervalued?
Well, the theory behind the discounted cash flow model is this;
The intrinsic value of a stock is the sum of all its future cash flows.
Put this into a mathematical formula, we arrive at this;
DCF = CF1/(1+r)^1 + CF2/(1+r)^2 + ... + CFn/(1+r)^n
- DCF = discounted cash flow
- CF1 = cash flow at period 1
- CF2 = cash flow at period 2
- CFn = cash flow at period n
- r = discount rate
- n = period
5 Easy Steps To Calculate Intrinsic Value Using DCF Analysis
There are many types of DCF models out there but what I'm about to share to you is the model I learned from the Wealthy Education course which I find very straightforward and easy to understand. You can purchase the entire course to learn more about the whole investing processes.
To calculate the approximate intrinsic value of a stock using DCF, you need to follow these 5 easy steps;
- Gather all the financial figures needed to calculate the intrinsic value.
- Calculate the Discount Rate or the Weighted Average Cost Of Capital.
- Calculate the Discounted Free Cash Flows from year-1 to year-10.
- Calculate the present value of 10-yr. Discounted FCF.
- Calculate the Intrinsic Value.
STEP # 1: Gather All The Financial Figures Needed To Calculate The Intrinsic Value
Get all the financial data listed below in the financial statements or in any financial websites like Morningstar.
- Free Cash Flow
- Shares Outstanding
- Growth Rate
- Current Share Price
- Total Liabilities
- Cash & Cash Equivalents
- Inflation Rate or GDP Growth Rate
- The Growth Rate can be calculated by projecting the company's Revenue, Net Income or Earnings Per Share by using CAGR formula or projecting the estimated YoY growth rates. Or you can just rely on analyst estimates (preferred).
- The Inflation Rate or GDP Growth Rate can be found in a number of sites like Trading Economics.
To calculate the Discount Rate, you also need to get the following data below.
- Interest Rate
- Business Tax Rate
- Market Value Of Equity
- Market Value Of Debt
- Stock Beta
- Risk-Free Rate
- Market Risk Premium
- Interest Rate can be found on the company's annual statements. In case you find it difficult, one method I use is to get the Interest Expense and divide it by the Total Debt.
- The Business Tax Rate in PH is 30%. You can also check Morningstar to determine an exact figure.
- Because MV Of Debt is a bit challenging to calculate, let's use the Total Debt as an estimated figure to ease the calculations and multiply it by 1.20. This is to assume that the MV Of Debt will be 20% greater than the Book Value.
- The Risk-Free Rate is the 10-yr. LCY Bond which can be found here.
- The Market Risk Premium can be found here. For the Philippines, it's 8.40% as of this writing.
- The MV Of Equity or simply Market Capitalization and Stock Beta can be found in any financial websites.
After getting all the required data, we now calculate the Discount Rate.
STEP # 2: Calculate the Discount Rate (Weighted Average Cost Of Capital)
In DCF, we can just assume any Discount Rate (e.g. 9%, 11%, 13%). But for the sake of accuracy, we'll use the Weighted Average Cost Of Capital.
The formula to calculate WACC is this;
WACC = (MV Of Equity/Total MV Of Debt & Equity) x Re + (MV Of Debt/Total MV Of Debt & Equity) x Rd
- Re = Cost Of Equity; Risk-Free Rate + Stock Beta x Market Risk Premium
- Rd = Cost Of Debt; Interest Rate x (1 - Business Tax Rate)
For the purpose of illustration, I'll use an imaginary company called XYZ Corporation. Let's assume the following figures below;
- Interest Rate: 3%
- Business Tax Rate: 30%
- Market Value Of Equity: 4 Billion
- Book Value Of Debt: 25 Million
- Stock Beta: 0.80
- Risk-Free Rate: 4.341%
- Market Risk Premium: 8.4%
First step is we calculate the needed variables in our equation;
Re = 4,341% + 0.80 x 8.4% = 11.06%
Rd = 3% x (1 - 30%) = 2.10%
MV Of Debt = 25 Million x 1.20 = 30 Million
Total MV of Debt & Equity = 4 Billion + 30 Million = 4.030 Billion
Next step is to substitute the values in the WACC equation;
WACC = [(4 Billion/4.030 Billion) x 11.06%] + [(30 Million/4.030 Billion) x2.10%] = 10.99%
We now have a Discount Rate of 10.99%. The next step is to calculate the Discounted Free Cash Flows from year-1 to year-10.
STEP # 3: Calculate the Discounted Free Cash Flows from year-1 to year-10
The first step is to get the projected FCF for 10 years. The equation for Projected FCF is;
Projected FCF = FCF x (1 + Growth Rate)^n
- FCF = Free Cash Flow
- n = number of periods
The next step is to calculate the discount factor for each period. The equation is;
Discount Factor = 1 / (1 + Discount Rate)^n
Going back to XYZ Corporation, let's assume the following figures below;
- Current Share Price: Php 1.00/share
- FCF: Php 200 Million
- Growth Rate: 12%
- Shares Outstanding: 4 Billion
- Discount Rate (WACC): 10.99%
- Cash & Cash Equivalents: 1.350 Billion
- Total Liabilities: 325 Million
Applying the formulas above, we now come up with the DCF for each period.
STEP # 4: Calculate The Present Value of 10-yr. Discounted FCF.
The next step is to add all the discounted cash flows to get the present value of all these cash flows. In our example, it equates to Php 2,102,428,819.06.
We need to also calculate the Perpetuity Value or Terminal Value of the business. The equation for that is;
Perpetuity Value = [Final Year's Projected FCF x (1 + Perpetuity Growth Rate)] / (Discount Rate - Perpetuity Growth Rate)
- Perpetuity Growth Rate = GDP Growth Rate
- The reason we use the GDP Growth Rate as the terminal growth for a company is because in reality, a business may not grow at a steady rate. At some point in the future, it will slow down and probably, growth would just be in pace with the economy. With that said, the GDP Growth Rate makes sense.
- You can also try using the Inflation Rate. This means that the business is growing in pace with the inflation rate.
We'll use 7% as our GDP Growth Rate. Substituting the values in the equation, we get;
Perpetuity Value = [621,169,641.67 x (1 + 7%)] / (12% - 7%) = Php 16,640,029,892.78
Discounting it back by using the 10-yr. discount factor, we get;
Discounted Perpetuity Value = Php 16,640,029,892.78 x 0.35 = Php 5,863,374,280.25
With all the data calculated, we now try to get the intrinsic value of the business.
STEP # 5: Calculate The Intrinsic Value
The equation to get the Intrinsic Value is;
Intrinsic Value = PV of Yr. 1-10 DCF + DPV + Cash - Debt
Intrinsic Value = Php 2,102,428,819,.06 + Php 5,863,374,280.25 + Php 1,350,000,000 - Php 325,000,000
Intrinsic Value = Php 8,990,803,099.31
This amount is the estimated intrinsic value of the business. To get the per share estimate, we divide the number by the number of Shares Outstanding;
Intrinsic Value Per Share = Php 8,990,803,099.31 / 4 Billion = Php 2.25
Notice that the current share price is lower than the Intrinsic Value. This means that the stock is undervalued.
To protect us from valuation errors, we can apply a Margin Of Safety. I use a minimum of 25% in my valuations.
Intrinsic Value Per Share = Php 2.25 x (1 - 25%) = Php 1.69
In this case, the stock is now almost fairly valued. You can now make a better decision based on the values you got.
Here's the summary of the calculations we did to get the Intrinsic Value of company XYZ;
To make the process of valuing less tedious and convenient, you can download the DCF calculator for FREE.
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If you have any questions and clarifications regarding the topic, kindly leave your comments below.
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