Discounted cash flow is one of the best ways I know of to value a business or stock. Using this method of valuing companies will keep you safe from over-hyped cash-burning IPOs. This is also the method that Warren Buffet and Charlie Munger use to evaluate investments. Discounted cash flow forecasts the expected cash flow that a company will generate and discounts that cash flow back to present value using an interest rate to get a net present value. The interest rate used in this is called the discount rate and is equal to the companies’ weighted average cost of capital (WACC). Companies will generally have a couple different growth rates during the forecasted time period. They might grow their cash flows at 10% for a couple years, then 5% for a few more years, then 3% in perpetuity.
Discounted Cash Flow Spreadsheet Calculator
You can also access this discounted cash flow spreadsheet as a Google Sheet here. This spreadsheet calculates the Net Present Value of estimated cash flows to determine the intrinsic value of the company. I use the numbers in millions. For instance, if a company’s next year cash flows are estimated to be $100 million, I input 100 into cell B5. Then I fill in the initial growth rate of cash flows, the terminal rate of cash flows, and the WACC or discount rate. The net present value calculates in cell B11 highlighted in cyan.
Discounted Cash Flow Example – Utz Quality Foods
Here’s an example using Utz, a private company based on good ole’ Hanover, Pennsylvania. I use this as an example because it is a brand that I grew up with and because Warren Buffett was interested in purchasing it. Buffett wanted to buy UTZ a few years back. It seems like a company he’d be interested in. It’s in a business that is easy to understand. They have a strong brand / moat. And their cash flows are very strong in comparison to their cost of capital.
Let’s say Utz’ cash flow is $100 million in 2017. Let’s also assume their cash flow is forecast to grow at 10% for the first 3 years, 5% for the next 2 years, then 3% in perpetuity. One more assumption: the discount rate used is 10%. You can start to see why being in finance is kind of like being a weatherman. This forecasting stuff is just that, a forecast and not reality. But it’s what we have to work with.
This is what Utz’ business value would look like given these assumptions:
The $1,963 terminal value is calculated by taking the cash flow times the terminal rate divided by the WACC minus terminal rate (terminal year cash flow * 1+terminal rate) / (WACC – terminal rate).
We would value Utz at $1.66 billion using these assumptions. That means that if we could buy Utz at a price lower than $1.66 billion it would represent a good value (creating wealth). Anything over $1.66 billion would mean we’re overpaying (potentially destroying wealth).
To put this in stock terms we could also say that Utz has 100 million shares outstanding. Then the value of the company would be worth $16.62 per share using discounted cash flow valuation. We’d buy it at $15 a share but not $20. That’s like 5 bags of chips.
Price per share of the stock doesn’t matter in an of itself. When you value companies, you want to know the total value of the company (intrinsic value using DCF analysis) and the number of shares outstanding. Take the intrinsic value of the company and divide by the number of shares to give you the price per share.
I talk to people about stocks sometimes and they say something like, “Google’s over $1,000 a share. It’s too expensive for me!” This makes zero sense. I don’t tell them that. I usually just say something like, “Oh, well if you get a larger share of the company for that higher prices, then it might be worth it.” I don’t care if a stock is $20 per share or $2,000 per share.
A lot of great stocks have a relatively higher share price: Amazon, Google, Chipotle, Berkshire Hathaway. These companies all have high share prices but that’s not what matters. What matters is the total value of the company at the time you’re buying it. If Chipotle is trading at $1,000 per share but the entire company is valued at $1 billion, I’d be a buyer all day long. In fact at that valuation, I’d do everything I could to buy as much of the company as possible.
One key to being an intelligent investor is not overpay for a company. Using the discounted cash flow method to evaluate companies is a good way to guard against this. The market continues to roll higher so it’s especially important to pick companies that aren’t overvalued. This leads us into the creation of wealth.
Creating Wealth Using Discounted Cash Flow Analysis
Consistently buying companies at prices less than their intrinsic value forces you to create wealth. Buying 1,000 shares of Utz at $10 per share would immediately add to your wealth. We calculated Utz’ per share value to be $16.22 per share so therefore buying it at a significant discount will add $6,220 to your future net worth ($16.22 – $10 * 1,000).
You won’t actually realize the increased net worth right away but this is the way I like to look at it (we can call it future net worth). It can take time for your investment to reach intrinsic value. Sometimes companies will never reach the intrinsic value you calculated by discounting their free cash flows. Using this method to buy many stocks across different sectors will add to your net worth over time. It’s only a matter of time before the value you calculated is realized in the market. Stay patient. Stay disciplined.