# Discounted Cash Flow (DCF) Valuation



## tonza (4 January 2010)

Just wondering how many fundamentalists here use a form of DCF analysis. I would like to know how you personally apply it, how you arrive at a figure for free cash flow, what model you might use to estimate a discount rate, your thoughts on terminal growth rates and how you attempt to estimate future cash flows.


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## hardcoremike (4 January 2010)

Sorry can't help much but I too would be very interested if someone can upload a full blown DCF/Free cash flow valuation model. I have studied valuation courses at Uni but still not convinced with the way textbook teaches versus how research analysts do it.

Cheers


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## Fleeta (4 January 2010)

Isn't one of the problems that many people use many different models and they can all throw out very different answers.

For example a terminal value may be calculated using a gordon growth model (or perpetual cash flows) or may be based on an EBITDA multiple number.

Discount rates are calculated using the CAPM model - usually fairly straight forward calc - most contentious variable is beta

i'd also be interested to see a model if anyone has one. I have seen quite a few in my line of work but these were to complete business combination accounting as oppose to business valuations.


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## UBIQUITOUS (5 January 2010)

I've used DCF for growth companies, and find the biggest room for error is when forecasting future year revenues. Basically with this model, its a case of 'rubbish in, even more rubbish out'. Nevertheless I find it useful as a guide to back up my decision on an investments. For example, I have used it for TZL and UNI. Both came back with valuations of many multiples of the current share price. However, TZL almost went into administration due to a corrupt board, and UNI is still largely ignored by the market.

So basically, you can use DCF to derive a valuation, but the market may never agree with you.


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## doctorj (5 January 2010)

UBIQUITOUS said:


> I've used DCF for growth companies, and find the biggest room for error is when forecasting future year revenues. Basically with this model, its a case of 'rubbish in, even more rubbish out'.



DCF is always tough and as you say, especially tough for growing companies.  It's much better suited to mature companies where the risks and value drivers are better known.

I'll have a look tomorrow to see if I can find a decent DCF model to share and perhaps we can work through the issues it raises.


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## UBIQUITOUS (5 January 2010)

doctorj said:


> DCF is always tough and as you say, especially tough for growing companies.  It's much better suited to mature companies where the risks and value drivers are better known.
> 
> I'll have a look tomorrow to see if I can find a decent DCF model to share and perhaps we can work through the issues it raises.




Excellent, and top topic to discuss!!


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## Ozymandias (5 January 2010)

UBIQUITOUS said:


> I've used DCF for growth companies, and find the biggest room for error is when forecasting future year revenues. Basically with this model, its a case of 'rubbish in, even more rubbish out'.




Exactly. The problem with DCF models is that the future earnings can only be educated guesses. Regardless of how complex or detailed the model is, it's only as good as your guesswork or extrapolations. But the complexity of these types of models can give many who don't know better a false sense of security.

Personally I would rather judge the value of a company on its known recent past, and what that roughly indicates for the short term future (1 to 2 years).

As many people have said before: "Better to be roughly right than exactly wrong."

Discussion point: analysts often forecast out as far as five years, but these are 'revised' (read: corrected) every six months or so. To my mind that's an admission that they were wrong in the first place!


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## moreld (5 January 2010)

Here's an old copy of my Price/Intrinsic Value spreadsheet It based on Hewitt Heiserman's 'It's earnings that Count'. Under the hood you'll find a discounted cash flow which I converted/perverted to be based on earnings. 
The web updates no longer work and I got too many requests for updates and fixes so have stopped providing a current copy. But the underlying DCF engine  should still work.

I believe analysts over use DCF, as so many of them seem to have engineering or similar backgrounds and Universities love to teach this highly theoretical stuff. DCF was designed for bonds and other annuities with known cash flows, not for growth companies. Still as someone said it is another tool that can help double check your other analysis.

I use a constant discount rate and interpret the results on an individual basis. i.e. while a growth company may appear undervalued and a utility fairly valued I then mentally factor in the risk of the growth company. That is subjective and has nothing to do with beta.

Hope that's of some help.


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## bilo83 (5 January 2010)

Major flaw of using DCF models such as Gordon to value growth companies is you can’t have earnings growth >= discount rate, otherwise you get an infinite val. I guess its unlikely that a company can sustain double digit EPS growth in perpetuity.   

I’ve found DCF models useful for small cap resources in estimating NPV of short mine life projects to get an idea of what the projects worth. Have found a few bargains that werent covered by analysts. These are still subject to commodity forecasts (I tend to use mix of spot and industry supply curve) capex, opex blowouts, grade etc. I also like to use a simple DCF to back out the market’s forecasts of EPS growth given a few assumptions about discount rates etc. You can compare the markets implied expectation against your own.


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## UBIQUITOUS (5 January 2010)

moreld said:


> Here's an old copy of my Price/Intrinsic Value spreadsheet It based on Hewitt Heiserman's 'It's earnings that Count'. Under the hood you'll find a discounted cash flow which I converted/perverted to be based on earnings.
> The web updates no longer work and I got too many requests for updates and fixes so have stopped providing a current copy. But the underlying DCF engine  should still work.
> 
> I believe analysts over use DCF, as so many of them seem to have engineering or similar backgrounds and Universities love to teach this highly theoretical stuff. DCF was designed for bonds and other annuities with known cash flows, not for growth companies. Still as someone said it is another tool that can help double check your other analysis.
> ...




Thanks for this Moreld.


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## doctorj (5 January 2010)

doctorj said:


> DCF is always tough and as you say, especially tough for growing companies. It's much better suited to mature companies where the risks and value drivers are better known.
> 
> I'll have a look tomorrow to see if I can find a decent DCF model to share and perhaps we can work through the issues it raises.



Unfortunately I haven't been able to find a DCF model I feel comfortable to share as they either relate to recent or ongoing transactions or too messy for general consumption.

DCF is a useful tool in helping to establish the value of a company.  It's not a silver bullet, but when used in conjunciton with other approaches (such as PE multiples, P/B, EV/EBITDA, P/OpCF etc) you can get a pretty good feeling of what a company is sensitive to and a ballpark figure of what it's worth.  I get pretty uncomfortable where the PV of the continuing value in the model >30% of the value in the company and where DCF vals far exceed the ball park given using simple peer multiples (this often happens in young growing companies).  I've seen models that go 3-5 years (eg. for a particular mine) and up to 40 years (for a life insurance company).  It's odd, sometimes you find things that you'd expect a company to be sensitive to, such as average mortality for a life insurer, to have little, if any impact at all for a specific company.  Other times, you find the only game in town is volume.

Developing a model is also a great way to familiarise yourself with a company.  Take a single mine company, with a gold mine.  You might find that they'll struggle if the gold price goes below a certain amount and how to respond to the non-linear impact of commodity price movements as they develop.


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## deedeeramone (12 January 2010)

The textbook FCF calculation (for Australian Equities) according to FINSIA is:

EBITDA
- Tax on EBIT
- increases in working capital
- capital expenditure (capex)
= free cash flow

Some more documentation on DCF Valuation can be found here.


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## Fleeta (18 February 2010)

I wanted to go back to this topic as I felt we could have explored what people take into account when 'valuing' a company on the ASX. I have attached a very simple model to value a company on the ASX (DTL). 

This model is very simplistic and assumes EPS = operating cash flows and then grows the EPS by 7% per annum for 20 years and discounts back at a WACC of 12%. Interestingly, page 29 of the 2009 annual report (note 16) states that their WACC is 10% pre-tax, which I think is low. It is an accounting requirement to disclose discount rates used by an entity for the purposes of impairment testing, so you can get a guide on any company's WACC from their annual report (although technically, these discount rates are on individual cash generating units as opposed to whole of entity).

Any thoughts on how good or bad this form of valuation attached is? Would love to hear any recommendations of what to build into a good model.

I should probably add that I don't have any opinion that DTL is worth $8.59 - it is just a model that calculates a number!


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