Discounted Cash Flow (DCF) was introduced in Part 1 with a small business purchase as an example. Here in A Guide to Discounted Cash Flow Part 2, we extend that to determine the intrinsic value of a publicly-traded company.
Imagine you are considering Microsoft (MSFT) as an addition to your portfolio. The company has performed well with a bright future. Total shareholder returns averaged 37% per year over the past three years. But, with the shares selling considerably higher, is it too late to invest?
Valuation of Microsoft
MSFT stock price is about $160 per share with a market cap of about $1,200 billion. Is MSFT worth that much? An estimate of intrinsic value is needed to know and make a wise investment decision.
Morningstar reports Free Cash Flow (FCF) was $38,260 million in 2019. And, it grew an average rate of about 8.6 percent over the past five years. Let’s assume it can continue growth at that rate for the next ten years. Let’s also assume FCF growth declines to 4% per year afterward. Microsoft also has about $134 million in cash and about $67 million in debt at the end.
Microsoft Intrinsic Value – Base Case
The Discounted Cash Flow for Microsoft is similar to the bagel shop. The discount rate, in this case, is an estimate MSFT’s cost of capital. And, an Excel Spreadsheet is used so we can also readily run some sensitivity analysis.
The table below shows, based on our assumptions, the intrinsic value of MSFT is about $1,784 billion (the FCF Equity Value) significantly above its’ current price of $1,200 billion.
That’s a good deal for a well established, high return, wide moat, and growing business. It’s on sale for about 2/3 of its fair value. That price also provides a 31% Margin of Safety to help offset unforeseen events or variations in the estimates.
Microsoft Intrinsic Value – Sensitivity Analysis
A sensitivity analysis provides insight into how the assumptions we make can change the outcome. This is particularly important with DCF analysis, where seemingly small changes can significantly impact the value.
The advantage of using an Excel spreadsheet for DCF analysis is that it lends itself to sensitivity analysis. Assumptions can be easily changed, and the impact on the results readily measured, as shown in the table below.
Notice how the changes after the explicit ten years forecast period significantly change the values.
The period after the explicit forecast, in this case, after the first ten years, determines the “present value of the residual” or “terminal value.” And, the terminal value typically makes up a large percentage of the total value.
There are two approaches to the terminal value: (1) assuming perpetual growth as in the Base Case above, and (2) using an exit multiple as illustrated below.
Calculate the Terminal Value with an Exit Multiple
In the Base Case Valuation above, the terminal value represents 77% of the total intrinsic value estimate. And, this substantial value is based on estimates starting ten years into the future.
The perpetual growth terminal value can be a source of significant variances in the intrinsic value estimates. So, some prefer to use exit multiples such as price to cash flow at the end of the explicit forecast period.
Let’s assume MSFT stock is sold after ten years for a multiple of cash flow. It currently sells for a high 32 X multiple of Free Cash Flow, indicating the willingness of investors to pay dearly for the company.
Here is the 32 X FCF Multiple Exit Valuation:
The intrinsic value of the 32 X FCF exit multiple is about $165 per share, providing a 14% Margin of Safety. This is just a little above the current price of the stock.
However, we are also assuming the multiple remains high ten years from now. An FCF multiple of 18 X for a quality company like MSFT would seem more sustainable. Let’s look at that.
Here is the 18 X FCF Multiple Exit Valuation:
The intrinsic value of the 18 X FCF multiple is about $129 per share with a -19% Margin of Safety.
At the 18 X, FCF exit multiple suggests the stock is already selling above its present value and not attractive to buy at this time.
What Valuation to Use?
So, what is the real intrinsic value of MSFT? The investor must use judgment to resolve this question. I believe it is probably somewhere between $185 and $230 per share.
Investing is part analysis and part judgment. The analysis provides precision and judgment approximations; both are essential. As we strive to be approximately right, not precisely wrong.
Why Discounted Cash Flows and Intrinsic Value Matter
Intrinsic value is the true economic value of a business regardless of what the stock price happens to be. It enables us to invest in a disciplined manner. It is how we know we are taking advantage of Mr. Market and not the opposite.
MSFT appears to be worth $185 to $230 per share. And if we want a 30% Margin of Safety, it should go on our watch list with a buy target of 70% of value or a price of $130 to $160 per share. It is in that range as I write this, but if it wasn’t we would wait for the market to offer it to us at that buy price.
“…you should do business with him (Mr. Market) – but only to the extent that it serves your interests. Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to. By refusing to let Mr. Market be your master, you transform him into your servant”
We also know that MSFT is reasonably priced at $185 to $230 per share. By understanding the underlying economic value of the business, we are not just guessing if it is a reasonable price. We can then decide to hold or sell based on what best suits us, not Mr. Market.
That’s disciplined investing and how we buy low and sell high.
Preparation Meets Opportunity
Knowing both the stock price, and the intrinsic value of the business is vital. It enables the individual investor to invest in a business-like manner.
“…intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.” Warren Buffett in the 1994 Berkshire Hathaway Letter to Shareholders
At times we just have to wait patiently for the price to fall below the intrinsic value. This may be for a long time while we accumulate cash. But when that happens, when preparation meets opportunity; good things happen.
Final thoughts on A Guide to Discounted Cash Flow
The critical components of investing include time, expected rate of return, size of future cash flows, opportunity cost, and margin of safety. Let’s address each one:
- Time: Money available now is worth more than the same amount in the future because of its potential earnings power. It can earn a return or interest now, money in the future cannot. The sooner money is received the better because it can potentially earn more. At a minimum, the discount rate considers the time value of money where relative valuations do not.
- Expected Rate of Return: Price is what we pay, and value is what we get. Price is visible; however, the value is discovered through analysis. Relative valuations methods compare prices, not values. And, without both price and value the return is unknown. DCF analysis estimates the intrinsic value of the business while the market provides the present value (price).
- Size of Cash Flow: Relative valuations consider cash flow for one point in time, if at all. DCF considers both negative and positive cash flow throughout the life of the investment.
- The Margin of Safety: The Margin of Safety compensates for errors in estimates and helps offset unforeseen adverse future events. And, the larger the Margin of Safety, the more room provided for error. A favorable margin of safety helps avoid permanent loss of capital. DCF analysis and the intrinsic value determines if a margin of safety exists.
- Opportunity Costs: Investors should always consider alternative investment opportunities to maximize returns. The bagel shop and bond example defined the opportunity cost of the bond investment to purchase the bagel shop. The DCF valuation provides meaningful and quantifiable comparisons between different types of investments.
What We Learned:
Discounted Cash Flow valuations capture the underlying fundamental drivers of a business, including the cost of capital, growth rates, reinvestment rate, etc. It comes closest to estimating the actual intrinsic value of the asset or business.
It works when there is a high degree of confidence in future cash flows. However, if operations lack visibility or a track record, it is difficult to predict future cash flows with certainty.
The single biggest criticism of Discounted Cash Flow is the terminal value makes up 65-80% of the total value. Minor variation in the assumptions on the terminal year, which can be ten years in the future, significantly impacts the final valuation.
The intrinsic value of a business is the present value of the future cash flows of the company available to pay its shareholders. And, Discounted Cash Flow is the foundation on which all other valuation methods.
Warren Buffett, one of the best investors in the world, advises us: “…intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Do your own independent research on any ideas discussed here. This is not a recommendation to buy or sell any particular security. Only opinions are expressed. You should consult a professional for personal investment advice that meets your specialized needs. This communication does not provide complete information regarding its subject matter, and no investor should take any investment action based on this information.
Wow. I am definitely going share this with a few of my friends. Very cool information.