Using Discounted Cash Flow Model to Calculate Intrinsic Value — Part 1
This is Part 1 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.
Summary
- Warren Buffet introduced Owner’s Earnings to refer to the part of reported earnings that actually benefit shareholders.
- Free Cash Flow is a good approximation of the Owner’s Earnings. It can be found on the Cash Flow Statement of a company.
Owner’s Earnings
Free cash flow is important because it’s relevant to the concept of Owner’s Earnings introduced by Warren Buffet.
At a time when Wall Street was using the net income of a company as an indicator to buy or sell its stock, Buffet introduced Owner’s Earnings. The idea is that we as owners (i.e. shareholders) should value a company by the earnings that it will generate for us. And only part of that net income is actually going into our pocket.
To understand this, let’s see what happens to the earning after it is produced —
- A part of it can be paid to shareholders as dividends.
- The rest of it will go back to the business. It might be spent on maintenance tasks so that the business can keep operating at its current level (e.g. repairing equipment). It can also be spent on expanding assets (e.g. purchasing investments).
Buffet thinks that owners of a business only benefit from the earnings that are paid as dividends or are used to expand assets.
When earnings are paid as dividends, they benefit the owners directly. When earnings are used to expand assets, they increase the asset value of the business, thereby increasing its market price and benefitting the owners. They are the Owner’s Earnings.
Free Cash Flow
At the time when Buffet introduced Owner’s Earnings, companies were not required to publish their Cash Flow Statements. Today we can find the Cash Flow Statements on most of the financial sites. And the Free cash flow on the statement is a good approximation to Owner’s Earnings.
As you can see from the red rectangle, Free Cash Flow = Operating Cash Flow - Capital Expenditure. Operating Cash Flow approximates the earnings in the diagram above. And Capital Expenditure approximates the maintenance expenditure.
You might notice that we are using Operating Cash Flow instead of Net Income that is also available on the report. This is because Net Income includes non-cash components (e.g. depreciation as an expense) that are irrelevant to our calculation. Operating Cash Flow is a more accurate representation of the cash available to the business and its shareholders.
There are some discussions around using capital expenditure to estimate maintenance expenditure. Some argued that capital expenditure can be used to expand assets in addition to maintaining current performance. However, many regard it as a conservative and simple approximate. In fact, Free Cash Flow and Owner’s Earnings are used interchangeably in the course.
Now that we understand what the Owner’s Earnings and Free Cash Flow are. Let’s introduce the Discounted Cash Flow model for estimating the intrinsic value of a stock.
The general idea is to use free cash flow to estimate the total earnings you will receive during your ownership, and then discount it back to today’s value.
There are 6 steps:
1. Estimate the free cash flow
2. Determine the short term
3. Estimate the short term growth rate
4. Determine the discount rate
5. Determine the growth into perpetuity
6. Find the number of shares outstanding
7. Calculate the Intrinsic Value —
Intrinsic Value = (Sum of short term cash flow + Sum of perpetuity cash flow)/(Number of shares outstanding)
In Part 2, I will go through each step using a real stock.
Feel free to leave a comment below to let me know if this article helps you. Have a wonderful day!
