Unlocking Hidden Value: A Comprehensive Guide to Determining a Company’s Intrinsic Worth through DCF Analysis
This article will teach you how to value a business using Discounted Cashflow Analysis by taking the example of Alphabet Inc.
Before we dwell deeper into how to do DCF Analysis, first we should know what DCF actually means.
What is DCF Analysis ?
Discounted cash flow (DCF) refers to a valuation method that estimates the value of an investment using its expected future cash flows. DCF analysis attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future. It can help those considering whether to acquire a company or buy securities.
In Warren Buffett’s own words (1992 annual report)
“The value of any stock, bond or business today is determined by the cash inflows and outflows — discounted at an appropriate interest rate — that can be expected to occur during the remaining life of the asset.”
Calculating the fair or Intrinsic value of a Business is very subjective, it could be very different for me and very different for you. It all depends on how a person thinks the business is going to perform in the future, what are it’s competitive advantages and many other factors as you will learn further.
Gathering the Information
First, we need to get the Annual Report of the Company we want to run DCF on. You can get the annual report from the Investor Relations section on the companies' website. Since, we are talking about Alphabet Inc. which is USA based, you can look for a form that says “10-K” because that’s how companies in the USA file their annual reports to SEC.
Calculation Free Cash Flow (FCF)
Free cash flow (FCF) represents the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.
Simply put, Free cash flow (FCF) is a company’s available cash repaid to creditors and as dividends and interest to investors.
Go to the FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA → CONSOLIDATED STATEMENTS OF CASH FLOWS in the annual report. The FCF is calculated by:
FCF = Net cash provided by operating activities — (Purchases of property and equipment + Proceeds from disposals of property and equipment)
Figuring out the Growth rate
In DCF, a growth rate is used to estimate a company’s future cash flows. A growth rate is very important as it assumes that the company is going to keep growing its Free Cash Flow (FCF) at that constant rate for 10 yrs (as in our valuation). Then we find a terminal value (we will get into this latter).
In the case of Alphabet Inc, it has very good growth rate of earnings and free cash flow. But for our calculations, we are going to be a little conservative and take the free cash flow growth rate to be 10% P.A.
Now, let’s talk about the terminal value. Terminal value (TV) is the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. We calculate Terminal Value (TV) as follows:
TV = 10th year free cash flow * (10 yr average Price to FCF ratio)
Price to FCF = Market capitalization / FCF
In case of Alphabet Inc, its 10-year Price to FCF ratio is 29.61 (Approx). So, our Terminal value comes out to be $13,57,914.6 Million. Your Excel sheet after this exercise should look something like this:
Figuring out the Discount rate
A Discount rate is equally important as a growth rate. A Discount rate helps us to discount back the future cash flows back to the present. A Discount rate should be taken as the rate of return you want to achieve with your investment. It shouldn’t be some absurd number that is far from the realty. The US Stock Market for 90 years has returned close to 10% return annually. So, for our case, let’s take a rate of 15% annually (Note: these all are hypothetical assumptions and there is no guarantee that these returns will be realized).
Let’s make a new column for our discounted cash flows. Keep in mind to take the first years (i.e., 2008) discounted cash flow to be N.A. Formula for DCF is as follows:
Now, your table should look like this:
where the formula for 2009 DCF looks like this:
and for 2018 it is:
Some Final things
Now, that we have got our Intrinsic Value of the company in terms of its Market Capitalization, we only need the shares outstanding of Alphabet Inc in 2018. Shares outstanding are all the shares of a corporation that have been authorized, issued and purchased by investors and are held by them. You can find the shares outstanding in the CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY of the company’s annual report. In 2018 Alphabet Inc shares outstanding stood at 13,903 Million.
We simply divide our Intrinsic Market Capitalization by shares outstanding in 2018 to get our intrinsic value per share of Alphabet Inc.
Final Result
Finally, we get our Intrinsic value of Alphabet Inc per share of $36.04 for 2018 using DCF Analysis.
Hope you would have understood now how to calculate the Intrinsic value of a business using DCF, though it requires a little practice to get a hang of it.
Disclaimer: This article provides information on Discounted Cash Flow (DCF) calculations using Google as an illustrative example. It is for educational purposes only and not financial advice. Individual financial decisions should be made based on thorough research and consultation with a qualified professional. The author is not responsible for any actions taken based on this information.
