Discounted Cash Flow (DCF) Analysis - Moat and Value Investing

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What is DCF Analysis?

Discounted cash flow (DCF) analysis is a valuation tool to estimate a company’s intrinsic value, compare it to the current stock price, and then determine whether the share price is undervalued, fairly valued, or overvalued.

The 5 Steps of DCF Analysis

A basic DCF analysis can be broken down into five 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

Step 1: Figure Out Current Free Cash Flow

Let’s go through the five DCF analysis steps using real financial numbers reported by Adobe.

The first step is to figure out a company’s free cash flows for the past four quarters (also called trailing twelve months, TTM).

Possible sources of where to find this information include Adobe’s quarterly reports (10-Qs), or websites such as MarketWatch or Morningstar which summarize the information.

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.

Adobe’s free cash flow for the past four quarters (TTM)

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.

Adobe's historic free cash flows (2011 to 2020), average annual growth rate (18.9%) and estimated 7-year annual future growth rate, g (15%) — Adobe’s historic free cash flows (2011 to 2020), average annual growth rate (18.9%) and estimated 7-year annual future growth rate, g (15%)

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).

Adobe's estimated long-term annual growth rate, l, of 3%. — Adobe’s estimated annual long-term growth rate, l, of 3%.

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 (read more on discount rates here).

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%.

Adobe’s estimated discount rate, d, 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.

Future cash flows split into two parts: cash flows for the next 7 years (growing at g = 15%) and from year 8 until the end of the company (growing at l = 3%).

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.

Calculation of Adobe's discounted future cash flows for the next 7 years, resulting in $59.8 billion. — Calculation of Adobe’s discounted future cash flows for the next 7 years, resulting in $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.

Calculation of Adobe's discounted perpetuity value (DPV), resulting in $210.7 billion. — Calculation of Adobe’s discounted perpetuity value (DPV), resulting in $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.

Calculation of Adobe's intrinsic value based on current free cash flow, discounted 7-year free cash flows, and discounted perpetuity value, resulting in $277.1 billion, of $576.02 per share. — Calculation of Adobe’s intrinsic value based on current free cash flow, discounted 7-year free cash flows, and discounted perpetuity value, resulting in $277.1 billion, 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.

Applying a 25% margin of safety to the $576.02 intrinsic value per share resulted in a margin of safety value of $432.01.

Price Evaluation

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.

Conclusion

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.

Final Thoughts

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.

It is better to be roughly right than precisely wrong.
John Maynard Keynes