Using Discounted Cash Flow Model to Calculate Intrinsic Value — Part 2
This is Part 2 of the summary of the concept and technique of the Discounted Cash Flow model from the book Warren Buffett’s Three Favorite Books and the course on Buffetts Book.com by Preston Pysh.
Recap
- In Part 1 we learned about Owner’s Earnings — a concept introduced by Warren Buffet to refer to the part of earnings that actually benefit shareholders.
- We also learned that Free Cash Flow is a good approximation of Owner’s Earnings. It can be found on the Cash Flow Statement of a company.
Overview
By the end of Part 1, I briefly talked about the Discounted Cash Flow Model.
A smart investor value a piece of land by how much crop it could yield. Similarly, we value a stock by how much earnings it can generate for us. Free Cash Flows are the Owner’s Earnings.
The general idea is that, in the short term, free cash flow will grow at a certain rate that is typically higher. After that the growth will slow down. We assume that the company is going to run forever and you will keep holding it and receiving your earnings.
To find the intrinsic value, we follow these 6 steps —
1. Estimate the starting free cash flow
2. Determine the short term
3. Estimate the short term growth rate
4. Determine the discount rate
5. Determine the perpetuity growth rate and the perpetuity cash flows
6. Find the number of shares outstanding and calculate the Intrinsic Value
Now let’s go through each step using WOW.ASX.
1. Estimate the starting free cash flow
Free cash flow typically changes every year and Preston suggested that we take the average of the free cash flows in the past ten years. I’m using the data of WOW.ASX from Morningstar from 2010–2019.
By the way, the data used in this article are exported to Google Spreadsheet from Morningstar Premium. You can also find the data in Morningstar Basic, however it does not support exporting to a spreadsheet.
2. Determine the short term
How many years do you think the initial growth will last for? I will use 10 here.
3. Estimate the short term growth rate
How much do you think the free cash flow will grow annually in the short term (i.e. 10 in this example)? Preston suggested that if you want to be conservative, you can use 3%, which is saying the company won’t grow and will just keep up with the inflation rate. Or if you are expecting growth you could use a higher number like 7% or 9%.
By looking at WOW’s data in the past 10 years, I am guessing there won’t be significant growth in the next 10 years, so I’m going to use 4%.
And this is what I have so far.
4. Determine the discount rate
The discount rate is your required return on investment. We can understand the concept with an example. If Bob asks to borrow $100 from me now and promise to pay back in a year with interest, what is the minimum return rate that I will be happy with?
Well, the current reported inflation rate is 1.8%. My bank is giving me a ~2% interest. And my ETFs generally yield a 7%-8% annual return. So Bob’s interest rate needs to be at least 8%. Also, there is the risk that Bob might break his promise and not pay me next year, so I will add a little bit to justify that risk.
Considering all these factors (i.e. alternative investments + risks), I will require at least a 10% interest rate from Bob. This is also saying that $110 from Bob in a year (with the risk) worths $100 to me now.
I will also use 10% as the discount rate to discount future cash flows from WOW. In the course Preston suggested that we use a generic 10% discount rate.
To discount the cash flow in the nth year, we divide the cash flow in that year by (1+10%)ⁿ, giving us its present value.
Sum up the discounted free cash flows we get from year 1 to year 10, we get $7,202.37
5. Determine the perpetuity growth rate and the perpetuity cash flows
After the short term, 10 years in this example, we assume that the business will keep operating. And we will be able to receive cash flows forever. But its growth will probably slow down a bit, which is what typically happens in the real world.
To estimate the rate of growth into perpetuity, Preston suggested that we use a conservative number and don’t go higher than the estimated inflation rate. I’m going to use 2%.
Also be aware that for the following calculation to work, we need the perpetuity growth rate to be less than the discount rate (i.e. 10% in this example). This is a fair assumption as it is very unlikely that the company will keep growing at a rate that surpasses the return rate of all alternative investments, and with the risk considered.
Using 2% as the perpetuity growth rate, here is the formula to find out the present value of the sum of all cash flows in the future.
If you are interested in how the formula is derived, here is a good explanation.
Using this formula, plugging in n = 10, C₁₀ = 1,432.73, g = 2%, d = 10%, we can get the present value of all the cash flow after the 10th year to be $7,042.83.
6. Find the number of shares outstanding and calculate the Intrinsic Value
Just a quick recap, we have
- Present value of the sum of short term cash flows= $7,202.37 mil,
- Present value of the sum of perpetuity cash flows= $7,042.83 mil,
- Present value of the total cash flows= $7,202.37 + $7,042.83 = $14,245.20 mil
To find out the intrinsic value per share, we need to know the number of shares that the company has. This can be located on most of the financial websites as Total Share Outstandings/Quoted.
As we can see, total number of shares for WOW = 1,263.1 Mil, this gives us-
Intrinsic value = $14,245.20 mil ÷$1,263.1 mil = $11.28 per share.
Thoughts
As you might have noticed, our intrinsic value deviates quite a bit from the market price ($34.45 as of May 2020). Does the market overvalue its price by over 200%? Or is there anything wrong with our models?
First it is not uncommon for the market to misprice something, as is the case with any economic bubbles. In fact it is the mispricing that gives those who can value things objectively good opportunities. However, we also need to understand the limitations of the DCF model.
The model relies on quite a few estimations — starting cash flow, short term growth rate, perpetuity growth rate and discount rate. Changes to any of these values can affect the outcome. Among them, the discount rate has the biggest impact. For example, lowering the discount rate from 10% to 5% results in an intrinsic value of $30.95 from $11.28.
Also making these estimations requires us to understand the business— how it makes money, what might be the upcoming challenges and opportunities. In this example we did not go into detailed analysis specific to WOW. This might be something we can do to improve our estimation.
Although if you ask me whether I will buy WOW now, I will probably not. I tried a more optimistic short term growth rate of 10% and a more generous discount rate of 7%, and I am only getting a $29.56 — still below the current market price.
If you are interested in experimenting with different inputs, here is a spreadsheet I prepared for you. Feel free to make a copy and play around with it (File > Make a copy).
Please leave a comment below if there are any questions or thoughts. I will be so happy to see your comments.🌟🌟
