What is the stock worth? You can look at the market price. However, the market price is subject to fluctuations that are actually part of the investor’s emotions. What you can do is to determine the stock’s intrinsic value.
The intrinsic value of stock gives investors an approximate figure of its fundamental value. It refers to what a stock is actually worth.
Calculating the intrinsic value of a stock is not difficult. Knowing an investment’s intrinsic value is useful, especially if you’re a value investor with the goal of buying stocks or other investments at a discount.
There are multiple methods to calculate intrinsic value. In this article, we’ll look at one of the most popular approaches – discounted cash flow (DCF).
Discounted Cash Flow (DCF) is Most Popular Method to Calculate Intrinsic Value of a Stock
Yes, DCF is the best known and most commonly used method to calculate the intrinsic value of stocks. And for good reason. In a DCF analysis, the cash flows are projected from assumptions about how the business will perform in the future and then using these assumptions to predict the cash flows generated by the business. And cash flow is the Holy Grail in valuations. That cash flow is then discounted to today’s value to know exactly how much the company is worth.
Some of the most significant advantages of the DCF valuation model are:
- very detailed model
- does not require comparable companies
- includes future expectations about business
- determines fair value of the company directly and precisely
- can be used in almost all scenarios
- not influenced by market fluctuations
There are also some downsides to the DCF valuation model, such as:
- sensitive to various assumptions and forecasts
- time intensive
- difficult predictions
There Are a Few Simple Steps to Calculating Discounted Cash Flow
The calculation of the DCF itself is not difficult for one who already has some experience in reading financial statements. For those who don’t, they’ll have to learn some things – but it will definitely pay off. By following the simple steps below you will be able to calculate DCF.
Make Predictions About Company’s Free Cash Flow (FCF)
This is usually done for a period of 5 years, although you can also do it for a period of 10 years. The longer the prediction period, the lower the accuracy of the model.
Most often, FCF is derived by projecting the line items of the Income Statement. As a result, the FCF results are sensitive to these assumptions about future operations. Errors in this part can greatly affect the final value of the DCF model, so it is necessary to carefully choose the growth rate of the future FCF.
Revenue growth is most commonly taken as an assumption to project FCF. The more detail you have while making this assumption, the more accurate your FCF projection will be. For example, if you know a company and can estimate how many products it will roughly sell in the future and at what price, you will have a more reliable estimate than if you take the total revenue.
Determine the Company’s Discount Rate using WACC
The next step is to calculate the company’s weighted average cost of capital (WACC) to determine the discount rate for all future cash flows.
WACC is a calculation of a company’s cost of capital in which both debt and equity are proportionately weighted. In the DCF model, WACC is used as the discount rate to project free cash flow to today’s value.
To calculate WACC we have to use the following formula:
WACC = K(e) x [E / (D+E)] + K(d) x (1 – T) X [D /(D+E)]
where K(e) is the cost of equity. K(d) is the cost of debt, E stand for the market value of equity, T for marginal tax rate and D for the book value of the company’s debt.
Calculate the Company’s Terminal Value (TV)
The calculation of terminal value is a critical part of DCF analysis because terminal value usually accounts for approximately 80% of the total net present value (NPV).
In the previous step, we calculated the FCF projections which go out as far as 5 or 10 years (depends on your valuation period). The terminal value represents the value of the cash flows after the projections period.
In the prediction of terminal value, the business should be assumed to grow at a rate that is appropriate for a business of its type at the end of the projection period.
You can calculate the company’s terminal value using Perpetuity Method or Multiple Method.
Perpetuity Method assumes that the Free Cash Flows of the business grow in perpetuity at a given rate. The Perpetuity Method can be calculated using the following formula:
TV = FCFn × (1 + g) ÷ (r – g)
where r is the discount rate and g is the assumed annual growth rate for the company’s FCF.
Terminal Multiple Method uses a multiple of a financial metric for the purpose of predicting the future earnings of the company. The most commonly used is EBITDA.
Calculate Intrinsic Value of a Stock
Discount the company’s cash flow and terminal value back to today’s value to get an enterprise value of the company. You can use the discount factor formula for this:
D(n) = 1 / (1 + r)^n
Where D(n) is the discount factor, r is the discount rate (which we previously calculated as WACC) and n is the number of years.
Now Compare Intrinsic Value of a Stock with Market Value
Now you will know the exact value of your company and you will be able to compare it with what the market thinks. If the intrinsic value of a stock is lower than the market value, it means that it could be a favorable opportunity to buy the stock. The difference between intrinsic value and market value, in this case, is called the margin of safety.
In case the market value is higher than the intrinsic value, the market values the stock more than our DCF model and it can be said that the market is too optimistic. It might be a wiser decision to wait for the market to reduce its enthusiasm and thereby wait for the market value of the stock to drop to an acceptable level of investment, which is our intrinsic value or below that value.