Investors have long sought to understand the intrinsic value of a stock through DCF assumptions. However, attempting to unravel the mysteries of these complicated calculations can be daunting and complex. In this blog post, we strive to unlock the secrets of accurately determining intrinsic value by demystifying the most important DCF assumptions involved.
What is DCF Valuation, and what is its relevance to intrinsic value?
DCF valuation, which stands for Discounted Cash Flow, is a method of estimating the value of an asset based on its predicted cash flows. DCF analysis is widely used to determine the intrinsic value of stocks, as it takes into account both the current and expected future earnings. Intrinsic value is calculated by subtracting the present value of these future cash flows from the current market value, resulting in an estimate of a company's or stock's true underlying worth.
Having reasonable DCF assumptions is critical to accurately determine intrinsic value. Poor assumptions lead to inaccurate projections of future cash flows, resulting in an incorrect intrinsic value. Conversely, accurate assumptions are essential. Therefore, investors need to understand the most critical DCF assumptions and how they impact intrinsic value.
Understanding the 5 Major DCF Assumptions
The five most important DCF assumptions are: (1) Revenue and cost projections, (2) discount rate, (3) terminal value, and (4) growth rates. Let's break down each assumption to better understand how they can influence intrinsic value.
1. Revenue and cost projections
The most important assumptions for any DCF analysis are the revenue and cost projections used to estimate future cash flows. Projecting revenues and costs accurately is critical to obtaining an accurate intrinsic value. When formulating these assumptions, investors must pay close attention to trends in sales, expenses, pricing changes, new product launches, etc.
The best way to do this is to study the current financial statements and observe how revenue changes have historically affected costs. An incredible hack is to use Wisesheets to create a model like this that pulls in the data you need for any stock and allows you to identify patterns faster:
Additionally, it is essential to consult industry and market data reports, which can be very helpful in obtaining insights on market and segment growth rates. For example, if you find in a report that the smartphone market is projected to grow at a 10% yearly rate and you are investing in a company that manufactures smartphones like Apple. You may use 10% or 5%, or any other number you think is reasonable in your DCF growth assumptions.
2. Discount rate
The discount rate is a critical factor in determining the present value of future cash flows. The higher the discount rate, the lower the present value and, thus, the lower the intrinsic value. It is important to note that different assets should be discounted at different rates to ensure accuracy. For example, if you are investing in a low-risk asset like government bonds, a lower discount rate would be more appropriate than it would be for investing in an equity security. Remember that the discount rate essentially represents the return you expect from an investment, plus a premium for risk.
Sophisticated investors often use WACC or capital asset pricing models to calculate the weighted average cost of capital, which they use as a discount rate for their DCF models, as it takes into account debt and equity in the company's capital structure. However, you can also keep things simple and pick a rate you are comfortable with. As they say, "Simplicity is the best form of sophistication."
3. Terminal value
Terminal value represents the projected future value of a company's cash flows beyond the time period modeled in a DCF. It is worth noting that the terminal value constitutes a significant portion of the overall intrinsic value calculation and requires accurate estimation.
To calculate terminal value, you can use either the Gordon Growth Model or the Exit Multiple Method. The Gordon Growth model assumes that cash flows will grow at a constant rate beyond the time period modeled in the DCF. It is calculated by discounting future cash flows using an appropriate discount rate.
For instance, if we assume that Apple Inc. has a 5% terminal growth rate, a projected free cash flow of $222 billion in the final year of the DCF model, and a discount rate of 10%, the terminal value can be calculated as follows:
Terminal Value = ($222 billion x (1+0.05)) / (0.1 – 0.05)
= $4.66 trillion
The Exit Multiple method assumes that the company will sell at a multiple of a metric such as EBITDA or Revenue. It is calculated by multiplying the estimated future metric by an appropriate exit multiple.
For instance, if we estimate that Apple Inc will have an EBITDA of $261 billion in the final year of the DCF model and assume an exit multiple of 10x, the terminal value can be calculated as follows:
Terminal Value = $261 billion x 10
= $2.61 trillion
For either of these methods, don't forget to return the value to the present value by discounting it using an appropriate discount rate.
4. Growth Rates
Growth rates are essential for estimating a business's future cash flows and its intrinsic value. Therefore, it is important to use realistic growth rates when constructing your DCF model.
The most common way to determine these growth rates is by looking at the company's historical performance in terms of revenue and earnings growth, as well as industry trends. Additionally, looking at analyst estimates can be very helpful in estimating future growth rates. Using the Wisesheets add-on, you can pull analyst estimates into your spreadsheet like this:
This allows you to sanity-check your assumptions and ensure that you use realistic growth rates.
DCF template for Google Sheets and Excel
Regardless of whether you use Excel or Google Sheets, we have a DCF template you can use that automates many of the processes of performing a DCF. All you need to do is download the template from either one of the links below and use the Wisesheets add-on on either platform.
Excel Download
Google Sheets Download
You can then modify the company ticker and assumptions, and the DCF calculation will be automatically performed for you.
How to Adjust the Assumptions to Reflect Your Business Model
The assumptions you use in your DCF model should reflect the company's business model you're analyzing. For example, if a company is growing very quickly, it would make sense to use higher growth rates than if the company was in a mature industry. Additionally, riskier companies should have higher discount rates than less risky ones.
It is important to remember that the assumptions you use in your DCF model will determine the output of your intrinsic value calculation. Therefore, it is essential to adjust them based on the specific business at hand and not just use general industry averages. A great way to do this is by looking at the historical performance of similar companies and adjusting the assumptions accordingly.
Examples of Using Different Assumption Scenarios in Your Valuation Model
Instead of using set numbers in your DCF assumptions, you can also see how different numbers affect the stock's intrinsic value. This is where sensitivity analysis comes into play. Sensitivity Analysis allows you to see how changing a single assumption (e.g., discount rate, growth rate, etc.) affects the company's overall value.
Running different scenarios allows you to gain an idea of the "value range" or the range within which the intrinsic value could potentially lie, depending on your assumptions and market conditions. This way, you can easily navigate your assumptions to better understand the intrinsic value. With this understanding, you can also put more emphasis and research on the assumptions that have a bigger impact on the company's value.
Conclusion
DCF is one of the most common ways of valuing a company, and it's important to understand how the assumptions used in the model affect its intrinsic value. By understanding and adjusting your assumptions, you can better understand the real value of a stock and make sound investment decisions. So, if you plan on investing in stocks, I recommend you do your own research and use a DCF model to get an idea of the intrinsic value.
To your wise investments! 🍷
