In Depth: How DCF Tool Works: Part 1

Discounted Cash Flow (DCF) models can become cumbersome to create, between collecting dozens of variables over multiple years and extensive calculations, manually building a DCF is less than enjoyable. While the purpose of DCF Tool is to handle all of these calculations automatically, this guide provides a full walkthrough example of how this site actually works. We strive for full transparency in how we handle calculations and also to effectively introduce everyone to this investing approach. For an overall look at DCF models, read here.

In today's climate, many beginners are diving deep into investing with no real background on how to value a stock. DCF Tool serves as the premier introduction to one way of finding stock value: DCF models. With that said, let's get to it!

Example Stock: WMT

We've chosen Walmart (WMT) for this example for several reasons: nearly every investor should be familiar with the company, they are well established and have seen relatively consistent financial performance. While consistency is not required, it does help DCF calculations be more accurate. The less consistent a company is, the harder it can be to predict how they will perform in the future, which makes the model more sensitive to any user input bias or error.

Historical Financial Statements

Every DCF calculation begins with pulling historical financial statements and gathering the necessary data. DCF Tool pulls up to the past 10 years of data if available.

The following are all required to perform the calculations, for each year:

• Capital Expenditures
• Current Assets
• Current Cas
• Current Liabilities
• Current Debt
• Taxes Paid
• Pre-tax Income
• Interest Income/Expense
• Depreciation
• Total Revenue
• Cost of Revenue
• Operating Expenses

You can find this information in the company annual financial reports, or more easily using your favorite stock market news website (Yahoo Finance, Morning Star, etc.) You will want to look under the financials section at the annual reports: Income Statement, Balance Sheet and Cash Flow.

For clarity, we'll walk through this calculation for the past 4 years. Combining all of this data into one table, you should have something that looks like this:

Earnings Before Interest (EBIT)

EBIT represents all of the money a company has earned in the given year, before taking out interest expenses.

EBIT = Total Revenue - (Cost of Revenue + Operating Expenses)

For 2017, this would look like:

EBIT = 500.343 - (373.396 + 105.51) = $21.437 Billion

Repeat this for each year. Note: EBIT is also commonly listed on financial news sites and can be used in lieu of calculating it here. This is shown for a supplemental understanding on how to find EBIT.

Tax rate

Like your personal finances, companies pay taxes as well. DCF Tool finds the tax rate using the equation:

Tax rate = Taxes / Pretax Income

For 2017:

Tax Rate= 4.6 / 15.123 = 30.41%

Repeat this for each year.

Changes in Net Working Capital

The annual change in net working capital (money) a company has to use for its business. For our purposes, this calculation excludes current cash and debt (note the subtraction of these in the equation below).

NWC = (Current Assets - Current Cash) - (Current Liabilities - Current Debt)

Change in NWC (for 2018) = NWC (of 2018) - NWC (of 2017)

For 2017, NWC would be:

NWC = (59.664 - 6.756) - (78.521 - 9.662)= -$15.951 Billion

The 2018 change in NWC would be:

Change in NWC (2018) = -15.472 - (-15.951) = $0.479 Billion

Repeat this for each year.

Unlevered Free Cash Flows

Finally, the key number we need: cash flows. Unlevered Free Cash Flows (UFCF) combines all of the values we have found so far into one equation:

UFCF = EBIT x (1- Tax Rate) + Depreciation - Capital Expenditures + Change in Net Working Capital

For 2018:

UFCF = 21.957 x (1 - 0.3735) + 10.678 - 10.344 + 0.479 = $14.57 Billion

Repeat this for each year.

Verifying DCF Tool Results So Far

At this point, your results should look like this:

Using these numbers, we can verify that the results DCF Tool gives match. Note that due to Walmart's financial reports being submitted for the following year, our "2018" result will show in 2019, which does not affect the final results.

DCF Tool Results:

As you can see, these match exactly to the hand calculations we have performed so far. Now that we have unlevered free cash flows for each year, we can start building up the model. Check out Part 2 of this article here for a continuation and the final results.