Wondering About Your Stock’s True Value? Discover It Here!

Are you ready to discover the secret to accurately valuing your stock picks? The Discounted Cash Flow (DCF) method is a powerful tool that can help you determine the true worth of your investments. By understanding the growth rate of a company, you can predict how its stock price will grow over time. Let’s dive into the step-by-step process of using the DCF method to value your stocks.

Discounted Cash Flow Method

Valuation 2 is based on Discounted Cash Flow. If you know the rate the company is growing, you can expect the stock price to grow in similar fashion. Growth can be measured in many ways. For example, we can look at company’s revenue, dividends, GDP, sales, cash flow, price to earnings ratio, and equity. Since you are measuring the rate the company is growing you will need series of data. This can be every quarter or every year. You can get data for any of the above growth rate and compare/contrast them to give you a better gauge.

We will revisit www.marketwatch.com to obtain this data and calculate the growth rate for “Free Cash Flow”. I like free cash flow, because as I mentioned earlier, if you have free cash to grow your business to me it triumphs all other numbers. Cash is king! You can do many things with cash, which you can’t do with tied up assets.

STEP 1
Let’s go back to marketwatch.com.

Ticker is FB –> Go to financial statements –> Cash Flow statement –> Click on “View Ratios” –> At the bottom of the sheet you will see “Free Cash Flow”:

These are the data for FB:

2013 – 2.86B

2014 – 3.63B 26.78%

2015 – 6.08B 67.57%

2016 – 11.62B 91.19%

2017 – 17.48B 50.49%

These figures are provided for you, and may vary little bit, since the number above are rounded to two digits and on excel calculation, they are rounded to 9 digits (based on it being in billion). If you get raw data and wanted to calculate your own growth rate. Use the following formula:

(2014 Free cash flow – 2013 Free Cash Flow)/2013 Free Cash Flow

(3.63B – 2.86B) / 2.86B = 26.92%.

STEP 2
Now, let’s identify some terms, so you know what we are calculating here.

Year: We are going to use data for last 5 years, if you can get 10years they may give you better indication. You most likely will have to pay for this data. Check with your broker If they are providing this information to you.

Cash Flow: This is how much cash is left over for the company to reinvest in itself, we have series of data to give us a rate.

WACC Formula: Weighted Average Cost of Capital, this is minimum return I expect to earn from this company. Your calculation of how much a stock is worth in the future, depends on how much return you are expecting from this stock. As a default I like to use between 7-15% minimum return. This obviously depends on the risk for that stock. For example, if the stock is risky, I would like to earn higher return, since I’m putting higher risk on the table. FB is also a technology stocks, they rise fast, and they fall faster. FB has earned great returns as of 2017. Those returns are usually not sustainable. When the company does fall, it will also fall hard, as most growth/tech companies do. Now let’s say through the fall and rise, I still expect 8% return here.

Discount Rate: How do you find the present value of investment that may be worth $1,000 a year from now, 2 years from now or 10 years from now? You will have to work backwards. In other words, you will have to discount this amount by a particular interest rate (WACC). Assuming WACC is at 8%, we will be discounting this by 8%.

Discount Rate Formula: (1 + WACC)Number of years discounted (1 + .08)1=1.08, (1 + .08)2=1.17, (1 + .08)3= 1.26, etc.

Present Value: Now that we know the rate and we know the future cash flow stream that we have forecasted, we can work backwards and figure out the what the current value or discount value should be. This would make sense since $1,000 now is worth more than $1,000 in 5 years, as long as WACC is greater than 0.

Present Value of Future Cash Flow: Future Value/ (1 + WACC)Number of years discounted

Cash Flow of 2.86B at 8% a year out would be worth 2.65B.

Cash Flow of 3.63B at 8% 2 years out would be worth 3.11B.

Cash Flow of 17.48B at 8% 5 years out would be worth 11.90B.

Perpetual Growth Rate: Rate at which company will continue to grow after the foreseen horizon that we have calculated for. The perpetuity growth rate is typically between the historical inflation rate of 2-3% and the historical GDP growth rate of 4-5%. The number to use here would be 2-5%, based on what your assumption on how well this company will continue to grow. Facebook is growth stock, it hasn’t reached a point where its growth has been capped. It may be more than 5 years before the stock reaches its full potential. Therefore, I’m going to use 5% here. This also depends on your horizon. How long are you planning on keeping this security? If you are going to get out before this security reaches its full potential, you can potentially raise the 5% as company is still growing.

Terminal Value: In this case, we are doing calculation on 5 series of data, however what would be the value on 10 series of data, 100 series of data or even infinite amount? Are we expecting FB to continue to grow at 8% forever? Probably not, at some point in time the company will grow as much as its going to grow, and from that point it will grow at a stable rate, using perpetual growth we will figure out its terminal value. Terminal value is sum of all cash flows from an investment after forecasted period at perpetual growth rate.

STEP 3
Calculation:
Terminal Value Formula: Final year of cash flow * (1 + perpetual growth rate)/ (WACC-perpetual growth rate).

=17.48b * (1 + .05)/ (.08-.05) =611.80b

Sum of Present Value of Future Cash Flow: Add up all the present value of future cash flow.

=2.65b + 3.11b + 4.83 + 8.54b + 11.90b= 31.02b

Present Value of Terminal Cash Flow: What would be the value of future cash flow at the last discount rate be worth today?

Formula: Terminal Value of cash flow/Discount rate for 2017

=611.80b/1.47b=416.38b

Total Present Value of Cash Flows: By adding the last 5 years of present value of cash flow (31.02b) + adding present value of terminal cash flow (416.38b), we have reached our total present value of cash flows.

=31.02b + 416.38b = 447.41b

Debt: This is your long term borrowing minus cash you have on hand. Now we will deduct any debt FB has. As of (12/31/17), FB doesn’t have any debt. If it did you would deduct this from $447.41b.

Our total value of Equity is 447.41b!

But we want to know price per share. To get this number we are simply going to divide the total value of equity by outstanding shares.

=447.41b/2.96b =$151.15 per share is value of our stock according to valuation 2.

There are, two variables you must play with here, WACC and perpetual growth rate! As I mentioned earlier, the perpetual growth rate is usually 3-5%. If perpetual growth rate is at 4% your price comes out to be $114.98.

The higher the return you expect (WACC), the lower you need to buy the security at. For example, at 9%, the value per share would be $110.87.

Fund managers who use 100% fundamental analysis want a deeper discount than just the value they calculated. They do this by using margin of safety principal. In accounting margin of safety is the difference between sales level and break-even point. In investing world, it’s the difference between intrinsic value and its market price. This is a widely used principal. Even if FB does come down to our calculated value, most value investors want a bargain, which is they want the price to be way cheaper than the value they calculated. This is the whole premises of getting a bargain and finding value in their investment. For example, if FB calculated value is $150 roughly and you are seeking 25% discount, you may want to buy FB around $113, at 50%, you would buy it around $75. Margin of safety is like a safety net, I may not completely understand everything about the business, and it gives me a cushion by buying the security cheaper.

You can play with these two valuations to get your stock in the ball park of what you might want to pay for it. As you do more valuation you will start to see which securities are clearly a bargain and which are not!

REMEMBER STOCK PRICE FLUCTUATE A LOT BASE ON THEIR POTENTIAL OF WHAT THEY COULD BECOME AT THE RATE THEY ARE GOING-NOT JUST WHAT THEY ARE TODAY AND SOMETIMES THE PRICE REFLECT THIS!

You can add securities that have passed all other parameters but are not at your bargain price to your watch list and set alert on them through your broker. You will be alerted when the stock comes down to your bargain price and then find the right entry point to buy them.

As I mentioned before, if securities are already at a bargain price, I still don’t just buy that security, but I conduct technical analysis to find the right time to buy them! I don’t use valuation as a hard and fast number, but it does give me a range. In this example we valued FB range somewhere between $130 – $150 roughly as of 2017 data. Currently (as end of 2017 the price of FB is roughly $180/share). This would indicate the stock is overpriced per our 2017 data valuation and would just put the stock on radar to alert us if and when it comes down below $150. Neither I or anyone can predict many things about FB or any other stocks, i.e. Scandal, lawsuits, takeover, etc. This will have a negative effect on stock. On other hand future prospect on what FB could become, takeover of smaller companies and continue growing users will have positive effect on the stock. Will it be the sole social media giant that will monopolize its industry? Hype will play into the price even if the data/earnings/sales do not. My point here is simple, valuation gives you a good clue but don’t buy/sell on it alone.

Another note about valuation, is that no matter what it indicates if historically the stock price keeps teeter tottering and not going anywhere, I don’t buy! In conjunction with valuation, I rely on technical analysis & charting. Once I target a company I like, I want to know when is the right time to get in and the right time to get out!