What is DCF Valuation?
DCF valuation is a method of valuing a stock that rests on the theory that a stock’s value is the present value of its future free cash flows (incoming cash after all expenses and taxes have been paid). When a stock will yield more cash flow to its equity holders over time than its current share price suggests, it is a worthwhile investment; when that statement does not hold true, the stock may be overvalued.
Creating a discounted cash flow model involves making two major assumptions that ultimately determine the merit of the model:
- Estimating how much cash flow a company will generate over the next X number of years
- Understanding how to discount future cash flows to understand their value to shareholders today
The StockNews Approach to a Conservative DCF Valuation
StockNews’ approach for determining these two inputs was as follows:
1) StockNews sought to estimate cash flows over the next five years. We started by calculating the compound growth rate in free cash flows over the previous five years (if five years worth of data was not available, we used however much cash flow data was available). We assumed the stock would be able to sustain this growth rate in free cash flow over the next five years, and so we used the most recent trailing twelve month free cash flow and modeled out the next five years of cash flow based on the compound growth rate in free cash flow over the previous five years.
2) After a five year period, we tested scenarios in which cash flow would grow in perpetuity by 0, 1, 2, 3, 4, or 5% annually.
3) Next, we needed to understand how to discount future cash flow back to the present. To do this, we needed to calculate a discount rate — essentially a percentage amount applied annually by which future cash flows need to be discounted. For instance, if a stock had a discount rate of 5%, cash flow 5 years from now would need to be discounted by approximately 27.62% (1.05 ^ 5). Calculating the discount rate can be somewhat complex endeavor, but it primarily boils down to two componen ts: how much a company pays for debt to continue its operations and how much it pays for equity its needs to finance its business. The weighted average of these two components ultimately determines how much a company has to pay to obtain the capital it needs to run its business, which is the most important part of determining a company’s discount rate and thus in building a reliable DCF valuation model.
Understanding Cost of Debt
Cost of debt is measured by observing the stock’s interest coverage ratio and its market capitalization, and mapping these values to Aswath Damodaran’s cost of debt table. Basically, as one may intuitively reason, the greater a company’s existing debt burden as measured by its interest payments relative to its earnings, the higher the interest rate the market will impose on the company for obtaining debt.
Understanding Cost of Equity
To calculate the cost of equity, we must consider two components:
1) The risk-free rate, which we treat as the current 10 Year Treasury Constant Maturity Rate.
2) The equity risk premium, which is essentially a calculation of how much additional compensation equity investors demand on top of the risk-free rate for taking the risk of investing in stocks. We once again rely on Aswath Damodaran for the equity risk premium number.
The sum of these two numbers gives us the cost of equity for a given stock.
Putting it All Together, With Inflation
The cost of debt, weighted by the book value of a company’s debt, is added to the cost of equity, weighted by the stock’s market capitalization. The result is a metric known as the weighted average cost of capital. To this number we add one additional number, in the interests of being conservative with our valuation model: the Federal Reserve’s five year forward inflation expectation rate.