Using a Python DCF Calculation to find the Intrinsic Fair Value of a Stock

Summary

This video explains how to calculate the intrinsic value of a stock using Apple as an example, distinguishing it from the market price. It introduces the discounted cash flow (DCF) model, which estimates a company's future free cash flows, applies growth assumptions, and discounts them to today's value. The tutorial covers obtaining historical cash flow data from Yahoo Finance, calculating terminal value, and determining a fair per-share price. It also emphasizes the importance of assumptions like growth rate and required return, and introduces the concept of a margin of safety. Finally, the video demonstrates implementing this calculation in Python for practical, real-time stock analysis.

Takeaways

• 📈 The market price of a stock, like Apple's $127.41 in January 2021, is different from its intrinsic value, which is based on future cash flow expectations.
• 💰 Intrinsic value represents the present value of expected future cash flows discounted to today's price using a required rate of return.
• 📊 Historical free cash flow can be used as a basis to estimate future free cash flows for a company.
• 🔢 The discounted cash flow (DCF) model calculates a stock's fair value by discounting projected future cash flows to the present.
• 📉 Terminal value accounts for all future cash flows beyond a specific forecast period and is critical for valuing long-term companies like Apple.
• ⚖️ Key assumptions in DCF include the required rate of return, perpetual growth rate, and near-term free cash flow growth rate.
• 🧮 Discounting future cash flows involves dividing the projected cash flow by (1 + required rate) raised to the power of the year.
• 📝 Small changes in assumptions, like adjusting the required rate from 7% to 8%, can significantly impact the calculated intrinsic value.
• 💡 Applying a margin of safety ensures a cushion below the calculated intrinsic value to account for uncertainties or risks.
• 🐍 Python can be used to automate DCF calculations, fetch up-to-date financial data, and estimate fair value per share programmatically.
• 📌 The DCF model helps investors understand whether a stock is overvalued or undervalued compared to its market price.
• 🎯 The model provides intuition for buying and selling decisions and calibrates investor expectations regarding stock prices.

Q & A

What is the difference between a stock's market price and its intrinsic value?

The market price is the current trading price of a stock on the market, while the intrinsic value is a fundamental estimate based on the company's expected future cash flows discounted to today's value.

How is intrinsic value calculated in the video?

Intrinsic value is calculated using the Discounted Cash Flow (DCF) model, which involves projecting future free cash flows, applying a growth rate, calculating a terminal value, and discounting all cash flows to today's value using a required rate of return.

What sources were used to obtain Apple's historical free cash flow?

Apple's historical free cash flow data for the past four years was obtained from Yahoo Finance under the 'Financials' tab, specifically from the 'Cash Flow' section.

What assumptions were made for Apple's future cash flow projections?

The assumptions included a 3% short-term free cash flow growth rate, a required rate of return of 7%, a perpetual growth rate of 2%, and a 4-year projection period for discrete cash flows.

What is terminal value and how is it calculated?

Terminal value accounts for all future cash flows beyond the discrete projection period. It is calculated as the most recent projected free cash flow multiplied by (1 + perpetual growth rate) and divided by the difference between the required rate of return and the perpetual growth rate.

Why is it important to discount future cash flows to today's value?

Because money in the future is worth less than money today, discounting future cash flows to present value allows investors to determine the fair value of a stock in today's terms.

How sensitive is the DCF model to changes in assumptions?

The DCF model is highly sensitive; small changes in the required rate of return, perpetual growth rate, or free cash flow growth rate can significantly impact the calculated intrinsic value.

What is a margin of safety and why is it applied?

A margin of safety is a buffer below the calculated intrinsic value used to protect against errors in assumptions or unexpected market changes. For example, if the intrinsic value is $84, one might target buying at $75–$76.

What Python packages and tools were used to automate the DCF calculation?

The `yfinance` package was used to fetch Apple's stock data, and Python loops and calculations were used to project cash flows, calculate discount factors, terminal value, and ultimately the intrinsic value per share.

Why is a perpetual growth rate typically set around 2%?

Because it should not exceed the long-term growth of the overall economy, which is typically around 2–3% for developed nations. Using a higher rate could unrealistically imply a company will outgrow the economy.

What is the practical application of calculating intrinsic value?

Calculating intrinsic value helps investors determine whether a stock is overvalued or undervalued compared to its market price, guiding buy and sell decisions.

How does the DCF model provide intuition about stock valuation?

It breaks down a stock's value into fundamental components—future cash flows and risk-adjusted returns—helping investors understand the relationship between a stock's price and its underlying financial performance.