The DIY Investing Podcast - 27 - How to calculate Intrinsic Value using Discounted Cash Flows (DCF)

27 - How to calculate Intrinsic Value using Discounted Cash Flows (DCF)

05/19/19 • 29 min

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How to calculate Intrinsic Value using Discounted Cash Flows (DCF) - Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode27

What is Intrinsic Value?

The present value of all future free cash flows produced by a business.

Time Value of Money

Cash today is worth more than cash in the future.
Therefore, you need to discount future cash flows to be worth less than their stated value.

The simplified discounted cash flow formula

Intrinsic Value = Owner's Earnings/(Discount Rate - Growth Rate)
- Discount Rates: 10% (nominal) or 6.5% (real)
- Growth Rates: Bounded between 0% and 5%
- Owner's Earnings: Manually calculated by adjusting Net Income

Complex Discounted Cash Flow Calculations

When to use:
- Company is in a high-growth phase of its business (has not yet saturated the market)
- You are highly confident in short-term projections and the business is predictable
- Reported earnings have a lot of temporary adjustments that make the next few years not match the long-term
When not to use:
- Almost always
- Why?
  - Complex calculations can trick you into thinking you have a better understanding of the business than you do
  - You'll likely rely heavily on growth and fast growth assumptions are very risky to make

References:

Part 1: Episode 23 - Discount Rates
Part 2: Episode 25 - Long-Term Growth Rates
Part 3: Episode 26 - Owner's Earnings
Example Intrinsic Value Reports [$10+/month Patrons receive exclusive access]

Please review and rate the podcast

If you enjoyed this podcast and found it helpful, please consider leaving me a review. Your feedback helps me to improve the podcast and grow the show's audience.

Support the Podcast on Patreon

You can find out more information by listening to episode 11 of this podcast.

How to calculate Intrinsic Value using Discounted Cash Flows (DCF) - Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode27

What is Intrinsic Value?

The present value of all future free cash flows produced by a business.

Time Value of Money

Cash today is worth more than cash in the future.
Therefore, you need to discount future cash flows to be worth less than their stated value.

The simplified discounted cash flow formula

Intrinsic Value = Owner's Earnings/(Discount Rate - Growth Rate)
- Discount Rates: 10% (nominal) or 6.5% (real)
- Growth Rates: Bounded between 0% and 5%
- Owner's Earnings: Manually calculated by adjusting Net Income

Complex Discounted Cash Flow Calculations

When to use:
- Company is in a high-growth phase of its business (has not yet saturated the market)
- You are highly confident in short-term projections and the business is predictable
- Reported earnings have a lot of temporary adjustments that make the next few years not match the long-term
When not to use:
- Almost always
- Why?
  - Complex calculations can trick you into thinking you have a better understanding of the business than you do
  - You'll likely rely heavily on growth and fast growth assumptions are very risky to make

References:

Part 1: Episode 23 - Discount Rates
Part 2: Episode 25 - Long-Term Growth Rates
Part 3: Episode 26 - Owner's Earnings
Example Intrinsic Value Reports [$10+/month Patrons receive exclusive access]

Previous Episode

26 - Owner's Earnings: Why Net Income or EPS can be deceiving

Please review and rate the podcast

If you enjoyed this podcast and found it helpful, please consider leaving me a review. Your feedback helps me to improve the podcast and grow the show's audience.

Support the Podcast on Patreon

You can find out more information by listening to episode 11 of this podcast.

Owner's Earnings - Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode26

What is Net Income?

The total after-tax profits that a company earns in a year

What is EPS or Earnings per Share?

The After-Tax profits of a company divided by the total number of shares outstanding.

The problems with Net Income and EPS as a metric for investment

They are not comparable across different companies and industries.
Some companies are more capital intensive than others.
Net Income and EPS will overstate the economic "cash earnings" for capital intensive businesses that require large capital outlays on a regular basis.

Implications for the usefulness of P/E Ratios

Since P/E ratios are based on Net Income or Earnings per Share for the "E" component, they share the same problems.
P/E ratios are not comparable across industries or even companies within the same industry

Owner's Earnings - A better metric

Definition:
Owner's Earnings - Earnings that can be paid out in cash to shareholders without impacting the earning power of the business

How to calculate Owner's Earnings

Take Net Income and make some adjustments
Joshua Kennon's formula is the best that I have found. See link below in the references.

References:

Joshua Kennon's Owner's Earnings Formula
Examples of how to calculate Owner's Earnings and Intrinsic Value [Intrinsic Value Reports - Exclusive to Patrons of $10+/month]

Next Episode

28 - How to earn Cash Back Online using Mr. Rebates

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You can find out more information by listening to episode 11 of this podcast.

How to earn cash back online using Mr. Rebates - Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode28

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