Website design By BotEap.comDespite many of the negatives we hear about DCF-based stock valuation these days, it remains a conventional method for stock valuation as part of fundamental stock research. In his 1992 Berkshire Hathaway (BRK.A) annual report on the DCF stock valuation method, Warren Buffett stated: “In the investment theory of value, written more than 50 years ago, John Burr Williams established the equation of value, which we condense here: The present value of any stock, bond, or business is determined by the cash inflows and outflows—discounted at an appropriate rate of interest—that can be expected to occur over the remaining life of the asset.” Many of the popular stock reporting group stock analysis resources trusted by retail value investors use this method of stock valuation. This article will examine the strengths and weaknesses of DCF-based intrinsic value calculations and why it is important for value investing.

Website design By BotEap.comLet’s review the main weaknesses of DCF-based stock valuation.

Website design By BotEap.comThe first is that it forces us to predict future cash flows or earnings. The data shows that most stock analysts cannot accurately predict next year’s earnings. At the macro level, the “experts” have a terrible track record in predicting jobless claims, the year-end S&P, or GDP. This is no different when it comes to projecting a company’s future cash flow by choosing stocks. We have to admit that we are tremendously limited in the ability to forecast future cash flows based on past results and recognize that a small error in forecasting can result in a big difference in stock valuation.

Website design By BotEap.comThe second challenge is determining the appropriate discount rate. What is the discount rate? Should we dust off our college or graduate school notebook and look at the CAPM, which calculates the discount rate as the risk-free rate plus the risk premium?

Website design By BotEap.comWell, ever since I learned this formula of the same kind (by business school finance professor) that convinced me as a wet 22-year-old student that markets are efficient, I’m skeptical. The public comments of the most famous value investor, Warren Buffett, on the subject have evolved, as he has stated that using the US Treasury rate world of long-term bond rates of 7%, we would certainly like to think that we are discounting cash flow after taxes at a rate of at least 10%. But that will depend on the certainty we have about the business. The more confident we feel about the business, the closer we are willing to play.” I am inclined to take these seemingly contradictory guidelines from Buffett and derive a reasonable estimate of the discount rate from there as part of my stock market research. September 2011 30-year Treasury yield at 3.51%, we should think that our discount rate for large-cap stocks is closer to 10% than the risk-free rate.

Website design By BotEap.comFinally, the problem with determining a feasible growth rate is that a DCF will simulate that the growth rate is eternal, and we know that no company can sustain an above-average growth rate in perpetuity.

Website design By BotEap.comLet us now turn to the strengths of a DCF model as a stock valuation tool.

Website design By BotEap.comGeorge Edward Pelham Box, a professor of statistics at the University of Wisconsin and a pioneer in the areas of quality control and Bayesian inference experimental models, commented:

Website design By BotEap.comAll models are wrong, some are useful.

Website design By BotEap.comI would argue that the DCF model can provide a useful stock valuation estimate as part of fundamental stock research if the user follows the following principles:

Website design By BotEap.com1. Invest in companies that have a sustainable competitive advantage. Investment in shares should be considered as ownership interests in these companies.

Website design By BotEap.com2. As Buffett alluded to in his 1994 letter, certainty in business is essential. Therefore, I look at different measures of stability in revenue, earnings, book value, and free cash flow as part of my stock research.

Website design By BotEap.com3. Your stock research must include due diligence in analyzing the companies’ finances (income statement, balance sheet, cash flow statement, efficiency ratios, and profitability ratios over at least a 10-year period).

Website design By BotEap.com4. Before using a DCF stock valuation model or a PE and EPS estimation method for valuation, kick the tires by using a valuation model that requires no assumption of future growth. Jae Jun at http://www.oldschoolvalue.com has some very good articles and examples on this topic (reverse DCF and EPV). I like to use the Earning’s Power Value (EPV) model (described below).

Website design By BotEap.com5. Look at simple relative valuation metrics like P/E, EV/EBITA, PEPG, P/B, etc.

Website design By BotEap.com6. Use conservative growth assumptions and a discount rate between 8-13%.

Website design By BotEap.com7. A good deal of intellectual honesty is needed not to modify the key growth and discount rate assumptions to arrive at a preconceived intrinsic value.

Website design By BotEap.com8. Always use a safety margin!

Website design By BotEap.comAs mentioned, I’m a big fan of Professor Bruce Greenwald’s calculation of the value of earnings power. The Earning Power Value (EPV) is an estimate of stock valuation which puts a value on a company from its current operations using normalized earnings. This methodology assumes that there is no future growth and that existing earnings are sustainable. Unlike discounted cash flow models, EPV eliminates the need to predict future growth rates and thus allows greater confidence in production. It is a valuable tool as part of a thorough stock research.

Website design By BotEap.comThe formula: EPV= Normalized Earnings x 1/WACC.

Website design By BotEap.comThere are several steps required to calculate the EPV:

Website design By BotEap.com1. Earnings normalization is required to remove the effects on profitability of firm valuation at different points in the business cycle. This means that we consider the average EBIT margins of the last 10, 5 or 3 years and apply them to the current year’s sales. This produces a normalized EBIT.

Website design By BotEap.com2. Subtract the average non-recurring charges for the last 10 years from normalized EBIT.

Website design By BotEap.com3. Add 25% selling, general and administrative expenses, as a certain percentage of selling, general and administrative expenses contribute to current earnings power. We use a default add-on of 25%. This assumes that the company can maintain current profits with 75% (1 entry) of selling, general and administrative expenses. The input range can be 15-25% depending on the industry. Where applicable, repeat for research and development expenses.

Website design By BotEap.com4. Add back the depreciation for the current year. We use a default add-on of 25%. This assumes that the company can maintain current earnings with 75% (1 entry) of capital expenditures. The input range can be 15-25% depending on industry CapEx requirements.

Website design By BotEap.com5. Subtract net debt and 1% income from normalized earnings (this is an estimate of the cash required to run the business)

Website design By BotEap.com6. Assign a discount rate (or calculate WACC if you wish).

Website design By BotEap.com7. Operating Power of Earnings = Company Earnings * 1/Cost of Capital

Website design By BotEap.com8. Divide the company’s EV by the number of shares to get the Price per share.

Website design By BotEap.comThe DCF share valuation model.

Website design By BotEap.comIn this 3-stage DCF model, free cash flow growth rates for years 1-5, 6-10, 11-15 and the terminal rate are estimated. The free cash flow sum is then discounted to present value.

Website design By BotEap.comThe formula for a DFC model is as follows:

Website design By BotEap.comVA = CF1 / (1+k) + CF2 / (1+k)2 +… [TCF / (k – g)] / (1+k)n-1

Website design By BotEap.comWhere:

Website design By BotEap.com• PV = present value

Website design By BotEap.com• CF1 = cash flow in year I (normalized by linear regression or average of 10, 5, 3 years of FCF)

Website design By BotEap.com• k = discount rate

Website design By BotEap.com• TCF = last year’s cash flow

Website design By BotEap.com• g = growth rate assumption in perpetuity beyond the terminal year

Website design By BotEap.com• n = the number of periods in the valuation model including the ending year

Website design By BotEap.comOnce again, we must recognize that the intrinsic value produced by our model is only as good as the numbers included in the model. If as part of our stock research we assume unrealistic growth rates (or terminal value) or discount rates, you will get an unrealistic intrinsic value result. No stock valuation model will magically provide completely accurate intrinsic value, but if you are conservative and intellectually honest, and dealing with a company with strong underlying economics as well as a long track record, you may find this method useful for identifying stocks. that are priced below their intrinsic value. Buffett seemed fine to himself using this methodology, so if you follow the principles above, you can too.