Intrinsic value is the true worth of an investment. A Discounted Cash Flow (DCF) analysis of a stock is aimed at estimating intrinsic value. I used the terms intrinsic value and fair value interchangeably. The whole point of smart investing is to get more in value than you pay in price.
Readers will know that there is an absolutely crucial distinction between price and value. Investors should keep in mind Warren Buffett’s words in the 2008 Berkshire Hathaway annual report: “Price is what you pay. Value is what you get.”
Sell side analysts’ reports that we looked at last week, see here, give a target price. They do not estimate fair value. DCF analysis estimates fair value.
The purpose of this post is to explain what a DCF analysis is, outline the main benefits of using them, point out the dangers and try to assist the reader to be a more discerning users of these reports. We do not need to learn how to actually carry out a DCF analysis.
Valuing a business
Buffett cautions us: “Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market you don’t belong in the game.” (Buffett, 1998) p.64.
It might be asked whether any investor can succeed if they don’t carry out their own research and make their own DCF calculations. In particular, typically the investor does not see the analyst’s estimate of future cash flows nor is there disclosure of the discount rate used. Quite a bit has to be taken on faith.
We can be comforted in the fact that we don’t need to value businesses perfectly. We just have to be smart users of the analysts’ reports. In fact, since we let someone else, an analyst, do the legwork, we can take a more objective view of the estimate. The person who has carried out the DCF calculation has a vested interest in its accuracy. As a user of independent financial analysts’ work we investors can accept or reject the opinions expressed. I often do. We must accept that there are tremendous inherent uncertainties in valuing a business. That is one reason we insist on buying with a margin of safety.
Here’s the key to the need for caution: DCF analysis relies on numerous uncertain assumptions and typically gives ridiculously precise estimates of intrinsic value.
Primer on Discounted Cash Flow analysis
What follows is a primer on DCF analysis. At a meeting with University of Maryland MBA Students on November 15, 2013, Warren Buffett explained the concept in the simplest possible terms. This is from notes taken by Professor David Kass.
“We generally think the value of a company is the PV [present value] of cash flows until judgment day.”
Discounted Cash Flow (DCF) valuation is a standard approach taught in business schools and is used by professional business valuators. It has been used for at least eighty years.
Two things are required to carry out the DCF valuation: an estimate of the cash that can be taken out of the business during its remaining life and a discount rate.
Future cash flows
Future cash flows are projections based on the company’s business franchise and its ability to generate free cash flow over and above capex needs well into the future. The process is essentially a business analysis of the prospects for the company. And when we think about it, it is difficult to see how a detailed projection of a company’s future cash flows in a quantitative spreadsheet can be particularly accurate even with the most sophisticated software programs. Assumptions have to be made of expected cash flows over the discounting period. This involves business judgement as to the future sustainability and growth of cash flows. No amount of sophisticated looking in the rear view mirror will replace business judgement. This is a source of inherent uncertainty in DCF analysis.
What follows may be where readers’ eyes glaze over. I invite you to persevere. Once you get the basic idea of discounting to present value, you will understand how uncertain the variables and assumptions are.
A discount rate is simply a rate used to discount future cash flows to the present time. It represents the rate of return the investor requires on their investment to provide a suitable return and compensate for risk. It is made up of a risk free rate and an appropriate risk premium attached to the nature of the investment (common stock) and to the specific company.
The risk free component is not as easy as one might think. As well, the company specific risk adjustment is problematic.
The best way to understand how a discount rate and a ‘rate of return an investor requires’ connect up is to use a simple investment example. Suppose you have $200,000 to invest and choose to put $100,000 into a bond with an expected total return of 4% over five years and $100,000 into a stock with an expected total return of 8% over the same period. If the investments works out as expected, the bond will accumulate to $121,665.28; the stock to $146,932.80.
What this little calculation has given us is the future value of two investments we make today under two different total return assumptions.
The flip side of this is to calculate the present value of future cash flows (DCF). Instead of compounding forward we discount backwards. We solve an equation for the present value of future cash flows by using a discount rate. The discount rate is the ‘expected return’.
It is perfectly intuitive to understand that a 4% discount rate produces a higher present value of future cash flows than an 8% discount rate. Put another way, for an investor to receive any particular set of future cash flows, if the expected return is less, they need a higher present value.
Put yet another way, for an investment that only needs a 4% return to attract investors, the present value of the set of future cash flows is higher today. For an investment that needs a return of 8% to attract investors the present value of the set of future cash flows will be less.
The difference between the two, the 4% bond and the 8% stock, is the comparative riskiness of the two investments. For a given set of future cash flows the present value of the bond is higher because it is less risky and future cash flows are discounted at a lower rate. Choosing the right risk free rate depends very much on the yields on ten year U.S. treasury bonds. But these have to be normalized if the Federal Reserve is manipulating rates. As well, there needs to be a risk premium to reflect the riskiness of stocks over bonds and a premium to reflect the riskiness of the specific company.
Needless to say, there is an art (not just science, not just computer output) to choosing the right discount rate for a DCF calculation valuing common stocks. This, of course, is also a source of inherent uncertainty in DCF analysis.
I have access to DCF analysts’ reports from three sources. I never cease to be amazed at the variation in estimates of intrinsic value as between the three. As well, the fair value estimates are usually lower than the target prices offered by sell-side analysts. I always keep in mind that an estimate of intrinsic value is only very approximate. The reports give a single figure, say $32. They really should give a range, say from $27 to $35 or even broader. The single figure gives an impression of precision that isn’t valid.
The main takeaway is that opinions of fair value based on DCF calculations are necessarily inexact (rightly vague?). But, at least they at least ask the right question. There are many uncertainties in the inputs and many uncertainties in the assumptions. Nevertheless, they are a very helpful for investor thinking about what would constitute a bargain price for a stock. The more uncertain the estimate the greater the need for a margin of safety in buying a stock.
To learn more about building a portfolio of stocks take a look at Chapter 38. The Problem of Determining Intrinsic Value
To read more deeply about the intelligent use of DCF reports, take a look at the following:
Section 38.01 Analysts’ reports
Section 38.02 DCF calculation – the inputs
Section 38.03 The cash that can be taken out of the business during its remaining life
Section 38.04 Discount rate
Section 38.05 Risk free rate
Section 38.06 Risk premium
Section 38.07 What discount rate would Buffett use today?
Section 38.08 Changes to intrinsic value
Section 38.09 An amusing quote on DCF from Warren Buffett
Section 38.10 Conclusion regarding DCF assessments of value
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