Let’s assume we identified a company that seems like a good investment. It has a wide moat, is financially stable, has little debt, is growing earnings and cash flows, earns high returns on invested capital, shows solid gross and net profit margins, and has reliable management.
Before making any investment, we now need to figure out one thing: is the share price cheap, fair, or overpriced?
What is Discounted Cash Flow (DCF) Analysis?
Discounted cash flow (DCF) analysis is a common valuation tool to estimate a company’s intrinsic value.
The intrinsic value is defined as the sum of the estimated future cash flows discounted back to today’s value using an appropriate discount rate. The intrinsic value can then be compared to the current stock price to determine whether the price is undervalued, fair, or overvalued.
The 5 Steps of DCF Analysis
A basic DCF analysis can be broken down into five simple steps:
- Figure out current free cash flow
- Estimate growth and discount rates
- Calculate discounted future cash flows
- Calculate intrinsic value
- Apply a margin of safety
Note that DCF models can be made much more complicated by factoring in additional variables. However, this doesn’t necessarily increase the accuracy, and the model presented here will get us the ballpark numbers we need to make a decision on whether share prices are under-, fairly, or overvalued.
To quote Charlie Munger: “The harder you work, the more confidence you get. But you may be working hard on something that is false.”
Let’s go through the five DCF analysis steps using real financial numbers reported by Adobe.
Step 1: Figure Out Current Free Cash Flow
The first step is to figure out a company’s free cash flows for the past four quarters (also called trailing twelve months, TTM). We could look through Adobe’s quarterly reports, found on Adobe’s investor relations website, but this requires too much digging and math.
Summing up, Adobe’s free cash flows for the past four quarters results in 1.31 + 1.68 + 1.71 + 1.89 = $6.59 billion.
Step 2: Estimate Growth and Discount Rates
The ultimate goal of a DCF analysis is to estimate how much cash Adobe can generate over its remaining lifetime. For this, we need to estimate three numbers:
- Annual growth rate of free cash flow for the next 5-10 years (g)
- Annual long-term growth rate (l)
- A discount rate (d)
Step 2a: Annual Growth Rate for the Next 7 Years (g)
A common approach for estimating future growth rates is to look at the past. Another approach is to listen to equity analysts who make predictions about future growth rates. However, as Aswath Damodaran, professor of finance at New York University, points out in his book The Little Book of Valuation, historic growth rates and analyst estimates show poor correlation to future growth rates.
Thus, the best thing we can do is to be conservative. As Charlie Munger said: “Ninety-nine percent of the problems come from being too optimistic. Therefore, we should have a system where the accounting is way more conservative.”
How long into the future we should estimate cash flows is up for debate. I’ve heard of M&A teams in financial institutions that use 5 years, since predictions further into the future get even more inaccurate than they already are. Other people use up to 10 years. We will use 7 years to be somewhere in the middle.
To find Adobe’s historic annual free cash flow growth rates, we can again look at MarketWatch, which provides the annual growth rates for the past 7 years. If we want to go further back, to 10 years, we either have to look through annual reports and calculate the numbers manually, or subscribe to a service such as Morningstar.com.
Adobe’s average annual growth rate for the past 10 years was 18.9% (see picture below). Note that the time period between 2016 and 2020 showed a significantly higher average annual growth in free cash flow (33.8%) compared to the time period between 2011 and 2015 (0.04%).
Based on these numbers, let’s assume an annual future growth rate (g) of 15% over the next 7 years. This is not too unrealistic, given that Adobe still has plenty of room to grow: current revenues are $12.87 billion, and the expected addressable market of 2023 is estimated at $147 billion.
Step 2b: Annual Long-Term Growth Rate (l)
The second growth number is for the time frame after the future 7 years. It is very unlikely that Adobe’s free cash flow growth will suddenly go to zero in year 8. However, it is fair to assume that the company’s free cash flow growth will slow down in the long term.
A sensible assumption for a long-term annual growth rate is 3%, as this is comparable to the historic average US gross domestic product (GDP).
Step 2c: Discount Rate (d)
Before we can start calculating future cash flows, we need one more piece: a reasonable discount rate (d).
The discount rate is like a reverse interest rate. It is required to discount the sum of all future cash flows to today’s (or present) value, because the same amount of money in the future is worth less than it is today. This is because of the time value of money, also called opportunity cost.
What is a sensible discount rate? Discount rates are affected by interest rates and business risk. Let’s have a look.
Impact of Interest Rates
Lower interest rates result in lower discount rates, because businesses can borrow money cheaper. A proxy for interest rates can be the U.S. 10-year treasury note, which as of this writing is at 1.34%.
Impact of Company Risk
The riskier the business, the higher the discount rate needs to be. This is because the likelihood of future cash flows actually materializing is lower than for a less risky business. Therefore, we want a higher risk premium, which means we need to discount at a higher rate.
Several factors affect a company’s risk:
- Size: Smaller companies are generally riskier.
- Debt: Highly leveraged companies face financial trouble during bad times and are therefore riskier.
- Cyclicality: Cyclical companies such as car manufacturers have less predictable earnings than for example Coca-Cola, and forecasted cash flows are thus less likely to actually materialize.
- Management: Management exhibiting risky behavior or allocating capital poorly generates more risk.
- Economic moat: A company with weaker competitive advantages is riskier than a company with a strong moat.
- Complexity: More complex organizations are riskier than more streamlined companies.
According to Pat Dorsey’s book The Five Rules of Successful Stock Investing, discount rates typically range between 7% (less risky) and 15% (more risky).
Given that current interest rates are low, and Adobe appears low risk (large size, moderate financial leverage, non-cyclical, wide economic moat, simple product portfolio, and excellent capital allocation), we can assume a discount rate of 8%.
Step 3: Calculate Discounted Future Cash Flows
Now that we have growth and discount rates, we can calculate all future cash flows. To do this, we need to split the future cash flows into two portions:
- Cash flows for the next 7 years (growing at g = 15%)
- Cash flows from year 8 until the end of the company (growing at l = 3%). These cash flows are called perpetuity cash flows.
Discounted Cash Flows for the Next 7 Years
The discounted cash flows for the next 7 years are calculated with the present value equation below. It may look a bit complicated, but once entered into a spreadsheet, it gets very easy to use.
Plugging in the numbers results in a sum of discounted free cash flows for the future 7 years of $59.8 billion.
Discounted Perpetuity (Long-Term) Value
Using the equation below, the long-term cash flows (= perpetuity value), are calculated using the free cash flow estimate in year 7 (grown at g = 15%), and the long-term growth rate (l = 3%). Finally, the perpetuity value gets discounted using the discount rate (d = 8%).
Applying the equation below gives us a discounted perpetuity value (DPV) of $210.7 billion.
Step 4: Calculate Intrinsic Value
Great! Now we are ready to put the numbers together and calculate Adobe’s intrinsic value. All we have to do is sum up the current free cash flow ($6.59 billion), discounted 7-year cashflows ($59.8 billion), and discounted perpetuity value ($210.7 billion).
This results in an intrinsic value of $277.1 billion.
Dividing this intrinsic value by the number of shares outstanding (481 million), as stated on Adobe’s most recent quarterly numbers, we get an intrinsic value of $576.02 per share.
Step 5: Apply a Margin of Safety
While the discount rate already factors in an assessment of risk, an additional safety measure against unknowns of the discounted cash flow model we just created, is the margin of safety.
The margin of safety reduces the estimated intrinsic value per share.
Depending on the complexity and riskiness of the business, the margin of safety should range somewhere between 20% and 50%. Riskier businesses require a larger margin of safety than less risky ones.
Based on Adobe’s wide moat, high return on capital, and moderate debt, I would categorize Adobe as low risk. Therefore, a margin of safety of 25% seems appropriate.
Applying the margin of safety to the intrinsic value per share ($576.02) gives us a per-share margin of safety value of $432.01.
Today’s share price of $661.00 is approximately 53% above our estimated margin of safety value per share of $432.07. Therefore, based on our assumptions, the current share price appears overvalued.
I hope with this post I was able to show you how DCF analysis can be used to value a company.
Keep in mind that DCF only gives us a rough estimate for a company’s intrinsic value, and the assumptions we made might be wrong and play out differently as the future unfolds. Thus, there is no 100% accurate way of determining a company’s actual value. But it’s the next best thing.
Tip: Download Our Free Moat & Value DCF Calculator Spreadsheet
Get the most out of this article and follow along by downloading our free DCF calculator spreadsheet (.xlsx). No strings attached.
- The five rules for successful stock investing, by Pat Dorsey
- The Little Book of Valuation, by Aswath Damodaran
- Valuation: Measuring and Managing the Value of Companies, by McKinsey & Company Inc.