Finding the value of a company matters a great deal; some would argue that it is the single most important item on anyone’s checklist. Figuring out how much the company is worth, or its intrinsic value will help you determine what price you should pay. And it determines what kind of long-term return you might achieve.
Using a discounted cash flow model or DCF is one of the more common styles of determining that value, but there is another option, the reverse DCF.
I like using DCF models to determine the value of the company, but there are pros and cons with DCFs, just as there is for any model. Some people make DCF’s sound like a terrible waste of time, but they aren’t as terrible as some think. As long as you are aware of the shortcomings, having a DCF is a valuable tool to have available.
The reverse DCF uses a lot of the same inputs required for a DCF, but it eliminates some of the variability in the DCF.
In today’s post, we will discuss:
- What is Reverse DCF?
- Shortcomings of a DCF
- How to Value a Stock With a Reverse DCF with Examples
What is Reverse DCF?
If you have ever read through an analyst’s report, you will most likely come across a valuation method known as a discounted cash flow or DCF. Using a DCF requires you to estimate future cash flows of the company, then apply a discount rate you think is appropriate for the risk level of the company. All of which leads you to a “precise” valuation or target price for the company.
One of the problems with using a DCF is that it requires us to use a healthy dose of guesswork to determine the growth of the future cash flows, along with the discount rates required to guess at the risk level of the company.
There is a solution to this guesswork problem, and that is by working backward as in a reverse DCF. Instead of projecting future cash flows, the reverse DCF takes the current share price and works backward to project how much cash flow would be required to generate its current valuation. Once we have determined the possible cash flows, we can determine if the price is reasonable.
Reverse engineering the DCF allows the investor to remove some uncertainty. The reverse DCF starts with the price, which we know from any stock ticker, and removes the doubt of projecting future cash flows.
If the reverse-engineered DCF assumes more cash flows than the company can reasonably produce, then the company is overvalued. If the opposite is true, then the company is undervalued.
Now that we understand what a reverse DCF is and the theory behind the process, let’s explore the DCF a little.
Problems with a Discounted Cash Flow
There are two types of valuation methods out there. The first being “relative valuation,” which uses financial ratios to indicate whether a company is expensive or cheap. By using ratios such as price to earnings, price to book, and price to sales, for example, investors can quickly determine whether a company is over or undervalued.
Relative valuation is helpful when comparing peers to each other. Still, it is rather imprecise as a tool for valuation because there can be many variables left out that determine the true worth of a business.
The other type of valuation uses models such as the discounted cash flow, which determines a much more “precise” value of the company by setting an absolute price by estimating future cash flows of a business over a five to ten year period and then determining how much we as investors should pay for those cash flows based on a discount rate back to the present value. Once those cash flows are valued when they are supposed to know whether the company is over or undervalued based on the current market price.
But, there are three problems with a discounted cash flow, mainly that we as humans are terrible at predicting the future.
- Projecting future cash flows – as mentioned above, all evidence points to the fact that humans can’t predict the future. And predicting future cash flows is no different. There is too much variable in predicting future cash flows, either based on historical numbers or projections. When making such forecasts, even a small error can lead to large changes in DCF valuations.
- Attempting to calculate an accurate discount rate – Determining the correct discount rate requires a deep understanding of how these rates work, which can lead to errors in valuation. Another potential problem is the tendency to adjust the discount rate to match the intrinsic value that you are seeking.
- Predicting growth rates for cash flows – The biggest issue with determining a reasonable growth rate is that any DCF model will project the growth rate to infinity. Unless we use a multi-stage DCF, the growth rate we project will go forward at least for ten years.
- Determining a proper terminal value – Unless you determine a stopping place, your valuation will go on forever with that current growth rate and no company, even Amazon will grow forever. Eventually, all companies return to the growth rate of the economy they are in; the alternative would be that Amazon would be worth the entire economy of the US, then the world.
A better alternative to some of these uncertainties of the DCF is to reverse engineer the model and start with knowns such as the price and work backward from there.
Let’s move on to valuing a stock with a reverse DCF using real examples.
How to Value a Stock With a Reverse DCF With Examples
Before we dive in and start to determine the value of a company using a reverse DCF, we need to make sure you understand how a discounted cash flow works. If you are uncertain, please check out this blog post to get a better understanding.
Now that we have an understanding of how the discounted cash flow works let’s start finding realistic values for our companies.
The first step is determining what discount rates we are going to assign to our formula and what terminal rate we will have going forward.
Let’s tackle the terminal rate, what I have found that works best is to take the GDP of the country you are investing in and use that the terminal rate projecting the cash flows into the future. With all the uncertainty surrounding the world, there would be nothing wrong with assigning the long-term rate of the 30-year bond, which is currently 1.65%.
Comparatively, the GDP rate currently is 2.1% according to most forecasts, but a warning that it is up in the air with the uncertainty related to Covid-19.
Using our models as we will see, you can play with the terminal rate along to see how it affects your number; I will use the lower or more conservative of the two for my models.
Next, let’s tackle the discount rates we will use. There are three lines of thought to tackle the discount rates.
- Use the risk-free rate, which is the t-bill rate you would assign to your investment for the rate minimum risk you would accept for this investment. Then you would add the risk premium for the country you invest currently. For example, the risk-free rate for a 10-year bond plus the US country risk premium, which are 0.84 and 5.6 respectively, giving us a discount rate of 6.44.
- The other school of thought is using the weighted average cost of capital or WACC. The formula for this discount rate is far more involved than I want to dive into currently, but if you are interested, you can find more information here. The simplest way to find the WACC if you are not interested in all the steps is to go to gurufocus.com, and they will calculate it for you. Using this discount rate is much more company-specific and uses variables such as debt, beta, long-term rates, and others.
- The last school of thought involves using the cost of capital or the CAPM formula, which involves using the beta or volatility of a company along with the risk-free rate and risk premium from above.
Each of these discount rates deserves a blog post for themselves, which is for another day, but for our purposes here, I am going to choose one and go with it. I will use the risk-free rate plus the market premium, so our discount rate for any company we choose will get a discount rate of 6.44.
Whichever discount rate you choose, you must be consistent; otherwise, you will run the risk of adapting your valuations to fit the price you are looking to buy.
The first company I would like to use to determine the current growth rate the market is pricing in for the share price is Walmart (WMT). The current market price for Walmart is $121.38.
Now we will attempt to locate the growth rate we think the market is pricing into the market value of Walmart basing that on the terminal growth rate of 1.65% and the discount rate of 6.44 based on the current risk-free rate and county risk premium. Other inputs we need to calculate the reverse DCF:
- Free Cash Flow TTM – $18,457
- Cash & Equivalents TTM – $14,930
- Long-term Debt + Short-term debt TTM – $76,475
- Shares Outstanding – 2849
Now we can determine using the data above the growth rate required to achieve the current market price.
By estimating the growth rate of the free cash flow and plugging the numbers into our model, I get the following ranges:
- 3% growth rate – $124.44
- 2.5% growth rate – $121.22
- 4% growth rate – $131.06
Based on the rates that we plugged in, we see that the market is anticipating that Walmart will continue to grow free cash flow at a 2.5% rate. Now we can look and see if this is reasonable by looking at the growth rate of the free cash flow over the last ten years.
Looking at the ten years annualized growth rate over the last ten years for Walmart, we get a value of 3.79%. Based on our reverse DCF and the historical growth rates of the free cash flow, it appears that Walmart is slightly undervalued or close to fairly valued.
Wasn’t that pretty simple?
Let’s take a look at some more since this is easy and kind of fun, I know I am a geek!
Let’s take a look at Apple (AAPL), which is currently trading at a market price of $351.85. Other data we need to calculate our reverse DCF:
- Terminal Rate – 1.65%
- Discount Rate – 6.44%
- Free Cash Flow TTM – $66,636
- Cash & Cash Equivalents TTM – $94,051
- Long-Term Debt + Short-term Debt TTM – $109,507
- Shares Outstanding – 4404.7
Now that we have all our data for our discounted cash flow, we can plug those numbers in and find the growth rate the market is pricing into the price of Apple.
- 4% – $352.98
- 3.9% – $351.41
- 3.8% – $349.84
Based on the discount rate, terminal rate, and current market price, Wall Street is pricing Apple to grow its free cash flow by 3.93% each year. Before freaking out, because that is what I did! Let’s look at the historical growth rate for Apple’s free cash flow before assessing the value.
Based on the CAGR of free cash flow over the last ten years of 14.71%, it would appear that Apple is currently undervalued based on the price of $351.85. Rather it appears that Apple has room to grow into its annual free cash flow growth rate.
That was interesting, wasn’t it?
Let’s take a look at one more just for giggles.
For our last example, I would like to analyze Verizon (VZ), which is trading at a market price of $57.76. Other data we will need for our reverse DCF:
- Free Cash Flow TTM – $17,540
- Cash & Cash Equivalents TTM – $7,047
- Long-term Debt + Short-term Debt TTM – $139,184
- Shares Outstanding TTM – 4141
After plugging in our data to the DCF model, we get a range of:
- 1% – $55.38
- 1.5% – $57.37
- 2% – $59.40
After adjusting the rates further, I arrived at a free cash growth rate of 1.6% for Verizon based on the current market price. Let’s look at the historical growth rate of Verizon to see if this is a good value.
After calculating the growth rate of free cash flow over the past ten years, we get a CAGR of 22.42%, which compares to our calculated our current growth rate priced into the market it appears that Verizon is undervalued based on current market price.
As I mentioned at the beginning of the post, the price you pay matters a great deal, and I fear that far too many investors have no real idea what is the intrinsic value of their company. Without this knowledge, we have no idea what return to expect over the years and whether it is a good investment or whether our money could work better for us elsewhere?
I use the discounted cash flow model to calculate my returns and what I think is a fair value for the company, but using the reverse DCF makes sense to me to determine what is a good growth rate for our company. I tend to focus on free cash flow as opposed to earnings when calculating my intrinsic value as I feel there is less opportunity for fraud in those numbers.
You can use free cash flow, net income or earnings, owners’ earnings, EBITDA, or EBIT as your cash flows. But the bottom line is you must be consistent across your valuations if you start mixing and matching according to your desire to find a number that matches your price, you can run into serious problems.
Remember that no formula or model eliminates working through your checklist to ensure you are buying a great company at a fair price. You can’t cut corners; we need to do the work. But the more you work through this, the better you will get.
That is going to wrap up our discussion today; I will include a simple DCF model I have created for your use if you don’t already have your own. It’s not pretty, but it will get the job done for you, or by all means, feel free to use your own.
As always, thank you for taking the time to read this post, and I hope you found something of value that can help you with your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time.
Take care, and stay safe out there,