Ways to Calculate Your Own Fair Value Estimate
There are numerous ways to value a business, and we cover many of them in our Price Vs Value: How to Know the Difference piece in our intermediate program.
No matter the approach, either those done on our platform or externally, they typically come under two approaches: either relative valuation techniques - comparing a stock to others, and intrinsic valuation techniques - estimating its value in isolation.
Relative valuation techniques are typically pretty quick to do because they’re usually a comparison of multiples and growth rates. But intrinsic valuation techniques involve a lot more brainpower, because there’s a lot more thinking required.
Here we’re going to focus on explaining two intrinsic valuation techniques that we can use to reach our own fair value estimates. And they are:
At a high level, a DCF involves estimating the present value of all the future cashflows that a business will generate over its remaining life. This is done by projecting out the next 5-10 years' worth of cash flows (sometimes with other inputs too), and the cash flows from then into perpetuity, then discounting all of them back using a discount rate to value them in today's dollars. We’ll delve into it shortly.
The future multiple approach is similar, but instead the investor estimates either revenue, earnings, free cash flows or some other metric out to a few years from now, 3-10 years, and then applies a multiple (like a suitable P/E ratio on that future earnings figure, or a P/S ratio on that future revenue figure), and then discounts that back to todays value. We’ll go into more detail on Future Multiple soon.
For now, let’s first look at what’s involved in a DCF.
A quick reminder, a stock price represents the market’s estimate of the present value per share of all the future cash flows a business is expected to generate for shareholders, over its remaining life.
And conducting a DCF aims to deliver us the exact same thing.
Conducted a discounted cash flow analysis can be as simple or as complicated as you’d like. There are multiple assumptions and estimates that need to be made, and depending on your confidence level, you may feel the simpler the better, or you may want that granular detail where you tweak 10 or more inputs for each year, to get a precise figure.
This also depends on how predictable to the company’s future is. If its Free cash flows are sporadic because the company is a tech startup or in a cyclical industry, then you may want some more precision over inputs over the next few years, or a DCF may note even be your best valuation option. If it’s a predictable business, then you may be happy with a simple DCF with a linear growth rate from its latest reported numbers.
We’d lean towards the simpler the better because often investors succumb to the false sense of security that more precision estimates mean a more accurate valuation. Remember, just because you have exact figures, doesn’t mean your valuation is right. As Buffett says, it’s better to be approximately right, than precisely wrong. To drive home this point, here are heaps of quotes from the best investors, attesting that simple valuations are better than complex ones.
He says he’s never done a “detailed” DCF, he does the math in his head (granted, he is a genius), but if he can’t do the math in his head, and the opportunity doesn’t “smack him in the face” that it’s clearly a good opportunity, he’s not going to tweak a few inputs by a few percentage points to get a number that justifies his decision. That’s what people succumb to when they do a very detailed DCF where they estimate multiple different line items into the future.
But with all that said, if you wanted to conduct a detailed DCF calculation with all those different inputs tweaked, go ahead, just keep that in mind.
For now, we’re going to focus on a simple DCF calculation, meaning this is what we need to do:
To do all that, we’re going to:
We’re going to focus on the “science” parts below, because the “art”, knowing what backs up a number, is mostly covered in our intermediate course: Part 2: Getting to know the business.
Estimating a company’s future will differ from person to person, because valuation is both an art and a science.
When it comes to forecasting the future cash flows, it can help to look at two different reference points - past trends and future expectations from analysts.
Let’s use Apple as an example since that’s the stock we worked through in the intermediate program.
Using a CAGR calculation, we can that over the last 6 years, Apple grew it’s FCF from $51bn to $99bn, an annual growth rate of 11.6%. Over the next 5 years, analysts expect it to grow from $99bn to $158bn, which is about 9.6% per year. In Simply Wall St’s DCF calculation, it extrapolates analysts forecasts out to an extra 5 years to reach a 10 year forecast of $196bn in FCF by 2033.
Which means, over that period from 2023 to 2033, cash flows are expected to grow from $99bn to $196bn, and that’s an annual growth rate of 7% per year. Since we’ll assume I’ve completed Parts 1-6 of the intermediate program, I understand the underlying business and its future prospects pretty well. It’s then up to me to determine if I believe that growth rate seems reasonable.
What growth projects does it have lined up that could spur this cash flow growth? Does it plan to expand into new markets (India), increase prices, or release new products (Apple Vision Pro) - all of which impact revenues? Or does it plan to cut costs (lower expenses)?
Another useful gauge for this is to read other investors opinions about the stock’s future. Reading investors narratives on Apple can give great qualitative context to help you make more informed estimates on what could drive free cash flow growth. Be sure to read both sides of the story to avoid confirmation bias.
So, let’s say based on my understanding and estimates of its future growth prospects, that a 7% FCF growth rate for the next 3 years seems reasonable, but I want to be conservative, so I’ll choose 5%.
That means I believe FCF can reach $162bn by 2033.
Next, we need to estimate a discount rate.
As they say, a bird in the hand is worth 2 in the bush. A dollar today is worth more than a dollar next year, simply due to the time value of money.
There are a few different ways to view a discount rate. One way is to view it as the minimum rate of return for what you’re looking for from an investment. People like Phil Town are well known for using 15% as their discount rate - an incredibly high hurdle rate which means many stocks don’t pass his strict criteria. Additionally, from an opportunity cost point of view, if you can hypothetically invest in government bonds (considered safer than stocks), and they generate a 5% yield, what extra return would you demand to be compensated from investing in this stock instead? An extra 2%, 3%, 4%? These numbers are the simplest way of picking a discount rate.
Another way to view it is you’re trying to account for the “risk” of the uncertainty of the future cash flows - the higher the risk, the higher the rate you’d use to account for that uncertainty.
Simply Wall St calculates a discount rate calculation using the 5 year average risk-free rate, the equity risk premium, and levered Beta. For Apple, at the time of writing, the discount rate was 8.2%.
So you can either choose to use Simply Wall St’s estimate, or you can choose your own by asking yourself these questions?
Let’s assume the current risk-free rate (typically the US 10-year government bond rate) is 5%, and you want an extra 3% return to be compensated for the risk of buying a stock instead of that risk-free bond. That’s very close to Simply Wall St’s estimated discount rate of 8.2%, albeit, it was calculated in a different way, so let’s pick 8%.
Now that I have chosen 8%, I can go into that spreadsheet and change cell C15 to 8%.
This has now discounted all the next 10 years' worth of cash flow estimates back to their present value! So next year when I expect it to generate $104.475bn in cash flow, but in today’s dollars, that’s worth $96.736bn. And so on for the next 9 years.
Next, we need to pick a “Perpetual growth rate”. This is our estimate for how much we think Apple will grow its cash flows from year 10 onwards for the rest of its life. It’s important here to be conservative, and the general rule of thumb is to use a country's long-term average inflation rate (typically between 2-3%), or its long-term GDP growth rate (4-5%).
If you pick over that top end of 5%, you’re essentially saying that you think the company’s FCF growth can outpace GDP growth…. indefinitely. Which is virtually impossible, since all companies slow down (and die), and some point.
So, for the purposes of this, let’s say we go with 2% since Apple is such a huge company already, and we should try and be conservative. Simply Wall St uses the 5 year average long term government bond rate, which is 2.2%, so that’s pretty close. Let’s put 2.2% into cell C18 of the spreadsheet.
Now that we’ve done that, the pre-written formulas do the rest of the work for us. We’ve estimated the growth in free cash flows, we’ve estimated a discount rate, and we’ve estimated a perpetual growth rate.
With all that, we’ve reached the end where the final few cells tell us that we estimate the present value of the stock to be $140.2 per share, and since the current share price is $182, the stock is 23% overvalued based on my estimates.
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Financial Data provided by S&P Global Market Intelligence LLC, analysis provided by Simply Wall Street Pty Ltd. Copyright © 2023, S&P Global Market Intelligence LLC. All rights reserved.