Calculating the intrinsic value of the company will be the last step in our Stock Valuing Process.

There’s definitely no reason for use to overpay for a company’s stock no matter how good the prospect of the company may look.

And thus, we need a valuation method to calculate the Intrinsic Value of a company.

There are 2 methods which I’m aware of.
- The Discounted Cash Flow (DCF)
- The Discounted EPS (DESP)

As I’m someone which is from a non financial background, I personally find the DCF concept a bit hard to grasp.

I personally uses the Discounted EPS  method, as I find it making more sense to me.

Anyway, you may use both, as I believe both of them should work well if you truely stick with realm of expertise.

I chose to share the DCF first because it’s the one method that are most widelyly used in today’s findamental analysis.

Here are the 5 steps for calculating a company’s FCF.

We are working on a 10 year FCF modal.

1. Forecast Next 10 years’ FCF (using
an estimated growth rate based on past FCF growth)
  • 1st, we need to know how much FCF will the company be able to generate for the next 10 years.
  • In order to do that, we need to estimate the possible consistent FCF growth for the next 10 years.
2. Discount these FCF to
Present Value (using a discounted growth rate value)
  • After having all the FCF that we estimate the company will be able to generate for the following 10 years, we need to discount it to present value.
  • That’s because, if the company is able to earn $1100 FCF next year, the value of that $1000 this year is only worth  $1000, assuming on a 10% growth rate.
  • Imagine that, if you were to save $1000 in a bank right now which gives you a 10% interest, what would you get back next year? Exactly. $1100.
  • That is why, a $1100 generate by a company which is expected to grow at 10% rate, is only worth $1000 today.
  • Just think of the Discounted Growth Rate as the annual compound growth rate that you are willing to settle for.
3. Calculate the
Discounted Perpetuity Value (using a perpetuity growth rate)
  • A stock can’t grow are a high value infinitely.
  • It will come to a time whereby that is the furthers the company could ever grow, and things start to get saturated.
  • That will be the time when the company’s growth will start to drop, and get steady, almost inline with the economic growth of it’s individual industry.
  • Most of the steady industry has a consistent growth of 3%. That will be the perpetuity growth rate we will be using for most of the companies.
  • As for companies which falls in already extremely matured industry, we will use 2% as the perpetuity growth rate.
4. Calculate Total Equity Value (which can be also
briefly assumed as the
Enterprise Value)
  • Now we need to know after 10 years, what is the TOTAL FREE CASH that this company is able to generate for us. That’s what matters.
  • Therefore, we need to add all the FCF generate by the company throughout the next 10 years.
  • … and also the Perpetuity Value.
  • Remember that everything we use to calculate the Total Equity Value needs to be Discounted to it’s present value, because that’s what we are interested at.
5. Calculate Per Share Value
  • After having the Total Equity Value, we now will need to divide it with the total outstanding shares.
  • This will give us the per share intrinsic value, which we can use it as a gauge to compare with the current market price of this company which is currently trading in the open market.

I know.

It is not easy, and pretty difficult to grasp.

The whole concept of this doesn’t seem to be making a bit of sense at all. It happened to me too.

But once you continue practicing, the understand will grow deeper, and you will slowly see the story bit by bit.

Let’s take a real case study from a company.

Let’s take a look into Apollo Group’s Financial Metrics.

1. Forecast Next 10 years’ FCF (using an estimated growth rate based on past FCF growth)

Here’s the snapshot of the FCF for the past 10 years.

By using the compound calculator, we get an compound annual growth for the past 10 years as 26.15%.

By using an excel spreadsheet, we need to calculate for all the next 10 years estimated FCF that the company will be able to generate.

2. Discount these FCF to Present Value (using a discounted growth rate value)

By using an excel spreadsheet, we managed to calculate the FCF for each and every year, for the next 10 years that APOL will be generating.

We even discounted it back to their respective Present Value, based on a Discounted Rate of 15%.

Anyone that follows my blog knows that my goal for long term investing is to achieve a 15% compound annual growth, and that is why I chose the Discounted Rate of 15%.

Here’s how it looks like
(the forecasted FCF is using an estimated growth rate of 26.15%, while the Discounted FCF is using a discounted rate of 15%)

3. Calculate the
Discounted Perpetuity Value (using a perpetuity growth rate)

Perpetuity Value = year 10 FCF x (1 + g) / (R – g)

where
g = perpetuity growth rate (3%)
R = Discounted rate (15%)

Plugging in the values, and this is what we get:-

Perpetuity Value = $6880 x (1 + 0.03) / (0.15 – 0.03)
= $7086.4 /0.12
= $59056

Discount it back to Present value, with the 15% discounted rate (using the compound calculator again), and we get a Discounted Perpetuity Value = $14,598.

4. Calculate Total Equity Value (which can be also
briefly assumed as the Enterprise Value)

Now this is easy.

Total Equity Value = Discounted Perpetuity Value + Total Discounted FCF
= $14,598 + $11,615
= $26,213

This will be the Enterprise Value of APOL.

If someone were want to acquire APOL right now, this will be the value that they at least have to come up with, to take over this company.

5. Calculate Per Share Value

Now, divide the Total Equity value by the Total Outstanding shares:-

$26,213 / 154.7 = $169

This will be the intrinsic value that we have reached, based on our 10 year modal Discounted Cash Flow on Apollo Group.

Well, APOL is currently trading at $50, which is like a 70% discount to it’s Intrinsic Value (if all the number’s we’ve plugged into our modal is what we truly believe in).

6. The Final Step

Was there a final step? I thought you said there were only 5 steps?

Well, you are right. :)

The previous 5 steps are just something that we need to understand how the entire DCF modal works.

Once you’ve understand how it works, we don’t need to go thru the entire painful process every time we want to calculate the intrinsic value for a company.

Because I’ve come up with a Discounted Cash Flow Calculator.

^_^

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tag : invest, stock, market, warren, buffett, value, growth, long, term, fundamental, analysis, discounted cash flow, dcf