Valuation Basics – DCF and Reverse DCF

Discounted cash flows (DCFs) are used to value a company by taking the sum of all future cash flows and discounting to the present value. DCF are contentious among value investors because of the large effect a small change in the assumed growth or discount rate has on the present value of future cash flows.

This is very true, small changes in the assumptions you make have a large effect on the present value of the stock. The way I look at it, a DCF is a sense check on the lower and upper bounds of a company’s value. You are not trying to determine a precise value of what the company is worth with a DCF. DCFs can also only be sensibly used on companies with sustainable cash flows. More on that later.

Let’s start with the basics. Using a DCF, you need to make assumptions about the following:

  1. Growth Phase

EPS or FCF per share growth expected in the next few years. I usually use 10 years for the growth phase of the business and I try to be conservative. You don’t need an overly precise estimate of this. I usually use a growth rate figure that is about half of the historical growth rate of EPS or FCF per share. If you are looking for the lower bound of a company’s worth, forecasting growth rates into the future that are identical or higher than historical figures would be overly optimistic.

  1. Terminal Phase

After the growth phase, the company is assumed to grow its EPS or FCF at a slower rate till perpetuity. 100 years is a good approximation for perpetuity. I usually use the long-term inflation rate of the country where the company’s main market is. For a company whose main market is the USA, I use a terminal growth rate that matches the long-term rate of inflation. A 3% nominal growth rate till perpetuity is 0% real growth because long term inflation has averaged about 3% in the USA.

  1. Discount Rate

There are many ways to measure the discount rate. I learnt a good way to think of the discount rate from Buffett. It is essentially your opportunity cost to investing in this asset. You could buy a ‘risk free’ 10-year Treasury or Gilt, you could buy the S&P 500 or the FTSE 350, or any other index tracker. The 10-year US Treasury is currently yielding 3% so you can get a risk-free return of 3% by buying this bond. However, interest rates have been artificially pushed down because of quantitative easing so this 3% figure is somewhat fake.

I prefer to use the long term annualised return of the S&P 500. Over the last 100 years, the S&P 500 has a nominal annualised return of 10% (including dividends). This 10% return of course depends on when you buy. Buying at a peak (say the dot com bubble in 1999), your annualised return up to October 2018 is 6%. Buying after the credit crunch in September 2009, your annualised return till today would be a much higher 14%.

Because the US market has done well over the last 10 years and the S&P 500 is expensive relative to its historical valuations, it is highly unlikely that an investor buying today should expect to see anything close to 14% returns over the next 10 years. Investors buying the S&P 500 today should expect returns closer to 6%. In any case, the precise figure is not particularly important. I always use a discount rate of 10% as my hurdle rate because this is the minimum return I am willing to accept in the long run.

 

The DCF formula is as follows:

With the formula, you are essentially finding the sum of all future cash flows (CF) from the business and discounting it to its present value with a 10% discount rate (r). In the first 10 years, cash flows grow at the growth rate discussed in the growth phase. In the terminal phase, they grow with inflation at 3% i.e. 0% real growth.

Sometimes I simply use a 3% growth rate during the growth phase which is what I did when valuing Fujitec. Even at such an unrealistically low growth number, I still found a 25% margin of safety and 34% upside.

Now the most important question about using DCFs. How sustainable are those cash flows over the long-term?

Does the company have a contract backing the cash flows?

A company needs to have some kind of contract with its customers before you can assume cash flows are sustainable. This can be a written contract between a company and its customers. For example, Teekay LNG provides transportation services to ship LNG (liquified natural gas). It has long term contracts with companies like Shell, Cheniere and Total going up to 2033 so there is some reliability in the cash flows. The problem is this type of contract is that its success is tied to the price LNG i.e. it depends on an externality that can’t be reliably forecast.

United Launch Alliance (ULA) – the joint venture between Boeing defence and Lockheed Martin Space also had sustainable cash flows, until the arrival of SpaceX. It operated on cost plus contracts with its client (the US Department of Defense) which meant ULA added together the material, labour and overhead costs for building and launching a rocket, slapped a nice margin on that number and charged the Department of Defense. ULA’s cost-plus contracts gave it a strong monopoly in the space transport industry before the arrival of another low-cost operator – SpaceX. Cost-plus contracts preserve a company’s margins and give it sustainable cash flows. They don’t guarantee that these cash flows will definitely be there in years to come, but they improve the odds. Investing is less about certainty and more about improving your odds.

The second type of contract is what I would call a metaphorical contract. This is not a literal contract between a company and its customers, but a product that has a high retention rate and sticky customers is likely to have sustainable cash flows. Apple is a good example of this. Its main product – the iPhone has retention rates between 80-90% meaning 80-90% of current iPhone users will remain iPhone users. I did a reverse DCF earlier this year when Apple was trading at $173. I was trying to figure out what kind of earnings growth will justify such a price. With a reverse DCF, you are trying to see how much a company’s earnings need to grow to justify its current price. For Apple, the reverse DCF had the following conservative assumptions:

  • 4% EPS growth during the ‘growth phase’ = 3% inflationary growth + 1% population growth.
  • 3% Terminal growth till perpetuity (100 years)
  • 10% discount rate

From the reverse DCF, Apple’s fair value was $172 and it was selling for $173 on the market. These assumptions were conservative because they ignore EPS growth due to iPhone price hikes (which Apple subsequently did) and it ignored share buybacks which will reduce the shares outstanding and increase EPS. A reverse DCF is a good sense check to see if a company is fairly valued but it can only be used for companies that have sustainable cash flows.

Kone is another example of a company with a metaphorical contract. Kone manufactures, installs and maintains elevators and escalators. The sustainable cash flows from their business comes from the maintenance contracts which are built on strong customer relationships. They install the elevator and you pay them maintenance fees. This business has a 95% retention rate. Once an elevator is installed, it’s quite difficult to take it out so the customer is locked-in. The 95% retention rate on the maintenance contract mean that they fail to capture only 5% of the maintenance contract fees after an elevator is installed. This is the perfect type of business to do a DCF on because elevators are like toll roads in the sky – easy to predict with a constant stream of cash flows.

Of course, both real and metaphorical contracts can be broken but having some kind of contract with the customer improves the odds of preserving those cash flows.

Before the internet and before the arrival of the discounters – Aldi and Lidl, consumer-packaged goods brands like Heinz and Campbell’s had metaphorical contracts with customers. They had shelf space in most of the stores people shopped in and they had a high switching cost i.e. many people wouldn’t risk trying ketchup that was not Heinz simply because they were familiar with the taste and the brand meant something to them. Back then, only large companies could afford to pay the gatekeepers of broadcast TV for adverts. Now, google AdWords and viral marketing has made it easier for competitors to steal market share from these big companies. Also, discounters like Aldi and Lidl sell cheaper, unbranded products and these discounters are rapidly gaining market share in the UK. With customers flocking to these discounters, the metaphorical contracts that the consumer-packaged goods had with the customers has been broken.

This is the hardest part of doing a DCF – determining how sustainable the future cash flows are. This is why I only use the DCF & reverse DCF as a sense check for companies that have sustainable cash flows. I am not looking for a precise number of a company’s value. I simply try to see what its worth in a worst-case scenario i.e. 3% growth rate from now till perpetuity and a 10% discount rate. If the price I get from that is below the current price of the stock, it could be a sign of good value.

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