By Jim Schoettler | More Articles

Discounted Cash Flow (DCF)

The concept of Discounted Cash Flow model valuation is straightforward: We discount all future cash flows the company will produce to the present day, add them up, and voila, we have our company valuation. With that, I present The Discounted Cash Flow Equation!

DCF = CF₀ x SUM[(1 + g)/(1 + r)] n (for x = 0 to n)

OK, OK. That’s not as pretty as my initial explanation. Here’s the basic interpretation: DCF is Discounted Cash Flow, CF₀ is today’s cash flow, g is expected growth, and r is the expected rate of return. For the many of you who wish that math had ended in third grade, let that suffice — we will look at how you can easily translate all that gibberish into a spreadsheet in a minute. For those of you who have to know exactly where that equation came from, my previous article is for you .

Buffett’s DCF valuations

As you read that section, I expect some of you were Foolishly thinking, What kind of cash flows? What kind of growth? What is the expected rate of return? Did I remember to turn off the stove?

Don’t worry, you turned off the stove. For the answer to the rest of these questions, we look to Warren Buffett.

Cash Flows and Growth: Buffett uses owner earnings, which he defines as:

Owner Earnings = Net Income + Depreciation — Capital Expenditures

Sound familiar? It should. This is essentially our beloved free cash flow (FCF)!

Obviously, then, it makes sense that the growth refers to FCF growth. We estimate future FCF growth from historical FCF growth — averaging over five or more years to smooth out yearly variations.

Expected rate of return: The expected rate of return is the opportunity cost of investing your money — that is, what you could reasonably expect your money could earn in a risk-free investment.

To find this number, Buffett uses the yield on the 30-year U.S. Treasury Bond — currently around 5%. Historically, however, the 30-year T-bond rate has been much higher (the 25-year average is around 8%). Since the expected rate controls the influence of future values on our DCF calculation (the higher the expected return, the less the future influences our calculation), we will be conservative and use the higher value (as Buffett does).

The expected return (r ) is used to calculate our discount factor (DF ):

DF = 1 / (1 + r) (n)

The present value (PV ) of any future value (FV ) received n years from now is just:

PV = FV x DF

Margin of safety: The Margin of Safety is Buffett’s signature investment principle, borrowed from Benjamin Graham. Buffett considers only companies that are trading at a significant discount (40% or more) to their DCF value. This margin of safety helps ensure reasonable return potential even if some of our assumptions are off.

Future growth assumptions

There are too many variables to accurately estimate what a company’s growth is going to be down the road. To help minimize errors, we make two conservative assumptions:

1. Growth will be steady for the next five years.

2. By year nine, the growth rate will decline to 3% (the rate of inflation).