Introduction to DCF Models

A brief overview of the value investor's favorite tool, DCF modeling

Mar 29, 2021

Discounted Cash Flow (DCF), is a financial model designed to forecast a company's free cash flows to determine the current intrinsic value per share of the company. Future cash flows are discounted to present value and combined with the terminal value of the company to find the net present value.

Discounted cash flows

DCF models can be highly valuable at estimating the value of a company when done properly, however all models rely on assumptions about the future performance of a company. Long term value investors like Warren Buffett and Benjamin Graham specialized in analyzing a company's performance to identify those that were undervalued based on these principles.

The key principle of a DCF model is that the value of the company (intrinsic value) can be found and that the company stock price should correlate directly to this value. DCF models can identify when there are discrepancies in these values, identifying to investors potential opportunities where a company is either over or undervalued based on DCF models.

DCF modeling is best applied to consistent, proven businesses that have steady revenues - preferably cash positive. Startup companies, high growth companies, and other similar businesses are highly volatile and more dependent on the input variables (future performance), which are inherently much harder to predict in these types of companies. In these cases, DCF models are less reliable and should be used sparingly.

Why Discounted?

Simply put, the value of a future dollar isn't worth as much as a dollar today. A variety of factors influence this result including inflation and opportunity costs. Depending on the level of inflation, each year that passes inflation slowly eats away the value of the initial dollar. Opportunity costs are another major reason why a future dollar is less valuable than today. Each dollar today could be invested in a variety of different places, each with their own levels of risk and expected returns. Combined, future cash flows must be discounted back to todays present value to accurately weight its value.

Discounted rate

There are two discounted rates most commonly used for a DCF model:

  1. Weighted Average Cost of Capital (WACC)
  2. Expected average return of the stock market (commonly ranging from 7-12%)

More about WACC can be found here: Investopedia.

DCF Tool automatically calculates the WACC for each company analyzed, and uses this as the default discount rate.

Two key assumptions in a DCF

  1. Revenue growth (Growth Rate) - inherently assumes operating margins and other
    company performance remain constant
  2. Terminal growth (Terminal Rate) - The company will grow forever at a specific rate,
    which is not guaranteed to be true

What is unlevered free cash flow?

Unlevered Free Cash Flow (UFCF) is the cash that's available to investors, or the value return you would see for being a partial owner of the company. Cash flows are the net flow of money made by the business available to both investors and the company for reinvestment (capital expenditures) for further growth.

Using unlevered free cash flows allows investors to to accurately compare any two businesses, adjusting balance sheets to any accounting differences between companies. UFCF also helps to accurately determine profitability of a company, rather than solely using metrics such as earnings or net income which can be misleading to investors.

DCF Tool automatically pulls company financials to calculate the unlevered free cash flows, as outlined below.

Calculations

  • EBIT: Earnings before interest and taxes.
  • Tax Rate: The tax rate paid by the company that year.
  • D&A: Depreciation and Amortization.
  • ΔNWC: Annual changes in Net Working Capital, excluding Cash and Debt.
  • CAPEX: Cash investments in company activities.

$$UFCF = EBIT * (1 - Tax Rate) + D\&A + \Delta NWC - CAPEX$$

$$TV = \frac{UFCF_n * (1 + r_{terminal})}{(r_{discount} - r_{terminal})}$$

$$NPV = \sum_{i=1}^n \frac{UFCF_i}{(1 + r_{discount})^i} + \frac{TV}{(1 + r_{discount})^{n + 1}}$$

2-Phase Model

DCF Tool is an inherent 2 phase model, separated by the Growth phase and the Terminal phase. In the Growth phase, companies are expected to grow at the defined growth rate as the business expands.This phase can be adjusted through the advanced parameters to any length of time, however this defaults to 5 years. It is not recommended to use both a high growth rate and an excessive number of years within the growth stage, as predicting each future year becomes less and less reliable.

2 phase DCF model

After growth comes the Terminal phase, which is essentially the expected long-term growth rate the company will see forever. Because the terminal value of a company can carry significant weight to the intrinsic value, this rate can greatly impact DCF accuracy. It should not be assumed that this is always positive, as companies in terminal stages could grow at a low positive rate, they could remain stagnant, or they could shrink in size - a negative growth rate. Carefully consider the long term viability of the business, and adjust this accordingly.

Stock Value

Finally, all of the individual future discounted cash flows and the terminal value are combined into a current total business value. DCF Tool pulls the number of outstanding shares and divides the business value by the number of shares. This then gives us a stock price that correlates directly to the calculated net present (or intrinsic) value of the company.