The DCF Model Explained - How The Pros Value Stocks/Businesses

Summary

This video provides a high-level overview of the Discounted Cash Flow (DCF) model, a method used to estimate the intrinsic value of a stock. The host explains the key steps involved in creating a DCF, from forecasting a company's future cash flows to determining its terminal value and calculating the weighted average cost of capital (WACC). While noting that the DCF is not perfect due to reliance on assumptions, the video emphasizes its usefulness in rationalizing stock prices and identifying potential buying opportunities. Additionally, the video is sponsored by Blinkist, a book summary app.

Takeaways

• 💡 The video discusses the goal of researching a stock to determine its intrinsic value and compare it to the current trading price.
• 🔍 There are various methods to estimate a stock's intrinsic value, with the DCF (discounted cash flow) model being one of the more detailed and defensible approaches.
• 📉 The DCF model involves forecasting a company's future cash flows and discounting them to account for the time value of money and the cost of capital.
• 📝 The video provides a high-level overview of the DCF model and the steps involved, without diving deep into every detail.
• 📊 The first step in the DCF model is to forecast the company's cash flows, which can be done using either free cash flow to firm (FCFF) or free cash flow to equity (FCFE).
• 🔄 The DCF model uses adjustments for taxes, depreciation, amortization, capital expenditures, and changes in working capital to estimate free cash flow to the firm.
• 📈 After forecasting cash flows for several years, a terminal growth rate is assumed to simplify future cash flow estimates.
• 🏦 The discount rate, typically the weighted average cost of capital (WACC), is calculated to discount the forecasted cash flows.
• 📉 The DCF model provides the enterprise value of the company, which is then adjusted by subtracting debt and adding cash to estimate the intrinsic value per share.
• 📚 The video emphasizes the importance of using conservative estimates and performing sensitivity analysis to gauge the stock's value under different assumptions.

Q & A

What is the main goal of researching a stock according to the video?

The main goal of researching a stock is to determine its intrinsic value, which allows investors to compare this estimated value with the stock's current market price. This helps in deciding if a stock is overvalued or presents a good buying opportunity.

What does the DCF (Discounted Cash Flow) model aim to calculate?

The DCF model aims to calculate the intrinsic value of a business by forecasting its future cash flows and discounting them back to their present value. This helps investors estimate how much the business is worth today based on its expected future performance.

Why is the DCF model not perfect?

The DCF model is not perfect because it relies heavily on estimates and forecasts, which are uncertain and may not pan out as expected. The value calculated through the DCF is only as good as the accuracy of these assumptions.

How can the DCF model still be useful despite its limitations?

Despite its limitations, the DCF model is useful because it helps investors rationalize the current stock price and see what assumptions the market might be using. If the model shows a conservative estimate of value that is higher than the current price, it can suggest that the stock is attractively priced.

What are the two types of cash flows you can use in the DCF model?

The two types of cash flows are Free Cash Flow to Firm (unleveraged free cash flow) and Free Cash Flow to Equity (leveraged free cash flow). The former accounts for cash available to both shareholders and bondholders, while the latter accounts only for shareholders.

What is the significance of discounting cash flows in the DCF model?

Discounting cash flows accounts for the time value of money, meaning that money in the future is worth less than money today. It also reflects the cost of capital, ensuring the cash flows are adjusted for the risks and costs of financing.

What is the purpose of estimating the terminal value in the DCF model?

The terminal value represents the value of the company from a certain point in the future (after the forecast period) onwards, assuming a constant growth rate. It simplifies the model by avoiding the need to forecast an infinite number of future cash flows.

What is the weighted average cost of capital (WACC) and why is it important?

WACC is the average rate of return required by both the company's bondholders and shareholders. It is important because it serves as the discount rate in the DCF model, reflecting the cost of financing the business and the risks involved in its future cash flows.

How does the DCF model adjust the calculated enterprise value to determine share value?

To adjust the enterprise value to share value, the DCF model subtracts the company's debt, preferred shares, and minority interests. It then adds any cash on the balance sheet and divides the result by the number of shares outstanding.

What are some of the limitations of the DCF model when applied to stock analysis?

The limitations include the heavy reliance on estimates for future cash flows, terminal growth rates, and discount rates. These estimates are uncertain, and small changes can significantly affect the final valuation. Additionally, the model assumes a constant growth rate after the forecast period, which may not be realistic for all companies.