If you read any of my company valuations posts, you’ll know I like to incorporate a discounted cash flow model when looking into the merits of a business. Make no mistake however, this is but one tool to be used when investigating a company, and obviously does not work under all circumstances (i.e. companies that don’t generate positive free cash flow). A discounted cash flow valuation can be as simple or as complicated as you want. I’d like to explore that idea a little bit.
There are aspects to a discounted cash flow model that are ubiquitous. I’ve tried a few different models over the past few years, all of which have of course included the free cash flow generated by the business. This is cash left over once investments in keeping the business running (property, plant & equipment) have been taken out. The remainder is therefore ‘free’ to be invested in paying down debt, paying out dividends, buying back shares, etc.
Different models use different cash flow parameters. Five year averages, ten year averages or future projections based on FCF growth for example. This is of course the crux of a discounted cash flow valuation and therefore why it isn’t suitable in all circumstances. A company that has to invest heavily in keeping itself running, leaving negative free cash flow will be essentially un-modelable (I think that’s a new word).
This will also impact younger, faster growing companies that may be diverting profits into growing the business. Whilst by no means young, Amazon is a fine example. Jeff Bezos has from the outset told investors he is more interested in top line (revenue) growth than generating higher levels of net income. Amazon therefore generate relatively little by the way of free cash, and a DCF will by definition under appreciate the merits of the business. Were Amazon to relax this mentality and start to generate real profit, this situation may change. A DCF may then become more viable as levels of free cash grow, and that growth becomes more predictable.
With some idea in place of the levels of free cash generated by the business, either historical or forward-looking, the next requirement is to consider growth rates. As mentioned, growth in FCF could be the determiner used in this case. In the original DCF model I used, a geometric average growth rate of the past five years of free cash was used to project growth into the future. I had some issue with this, as free cash flow is seldom steady & consistent, particularly for faster growing companies. A geometric average therefore can give some rather strange results if cash flows vary wildly from year to year.
I tend to be drawn to companies with relatively consistent historical growth in free cash, which often correlates with growth in net income. This obviously allows for a level of predictability, which lends well to growth models based on both values. I will therefore tend to look at growth rates in both net income and free cash flow and determine a range of possible intrinsic values based on both.
Discounted cash flow measures tend to model growth for a set number of years, and then assume growth rates slow to a set value in perpetuity. By default I tend to use a figure of 3%, which roughly approximates an average level of inflation. This assumes that the business will at least be able to raise prices in line with inflation which, if steady, will fall to the bottom line.
In many ways this feels as though it is the most contentious element to a discounted cash flow valuation. Warren Buffett said it best when discussing the purpose of the discount rate:
“The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.”
Put simply, if I’m estimating all the future cash a business will generate, I’ll want to discount that cash by an appropriate rate for the risk I’m taking in investing in that business. £100 a year from now is not worth £100 today, therefore it needs to be discounted by an appropriate rate.
I mentioned in the beginning that a DCF can be as simple or as complicated as you want to make it. I’ve seen models that use a variety of techniques to determine what an appropriate discount rate should be when determining the value of a business. At the extreme end, a model based on the weighed average cost of capital (WACC) requires assumptions about how much a company is expected to pay to debt and equity holders to fund operations. Calculations are required when looking at the debt a company has and how much it pays to service that debt (i.e. the rate of interest on bonds). It is also necessary to establish the cost of equity, which in my experience is less precise and more assumption-based.
I’ve also seen models that incorporate the beta of a company in determining a valuation. The beta is sometimes used as a proxy for the measure of the riskiness of a business, and measures the volatility of that business relative to the wider market. Confused yet?
In recent years I have gotten rid of all of this, for two main reasons: One, the discount rate is but one variable in an overall discount cash flow valuation, and is susceptible to moderation along with the other variables. Two, a discount cash flow valuation is only one tool when looking at a business. It presents a set of guidelines, not hard and fast rules. Buffett and Munger are believed to keep it simple. Their discount rate is the yield on the 30-year US Treasury rate. In using this, they establish a consistent base line when comparing equity valuations, rather than adjusting them individually.
Are Equities Cheaper?
So what did I mean when I suggested equities may be considered “cheaper” right now? I like the idea of using a consistent rate when looking at company valuations. Buffett uses the 30-year rate as a “risk-free” rate as the likelihood of default on US treasuries is considered extremely low. It’s fair to say that same rationale applies to UK government debt and can be used in the same way.
The yield on 30-year Gilts currently stands at 1.945%. This has of course historically been higher, and in fact we are still in the midst of a multi-decade bond bull market. If the discount rate is a proxy for our required rate of return on an equity purchase, is it therefore necessary to reduce our demands (and therefore our discount rate) when risk-free rates are lower? How would that look in practice?
Nothing is certain but death and taxes. With that in mind, I wanted to look at Dignity PLC as an example of a steadily growing company with relatively predictable growth in net income and free cash flow. The company is not exactly ‘cheap’ on the following valuation metrics:
- P/E – 18.5
- P/B – 40.2
- P/S – 3.5
- P/CF – 14.4
- Yield – 1.08%
Dignity have a ten year revenue growth rate of 7.34%. Net income has grown at a compound rate of 10.74% over the same ten years. Free cash flow is 7.62% higher on average over this period. Pretty steady growth across the board. We can start to use these numbers in a discount cash flow valuation.
Whilst free cash flow has grown, it hasn’t been necessarily steady. This isn’t a problem. Businesses will naturally have periods where investment in the company is higher or lower depending on its needs. TTM free cash flow is £50m, but a ten year average works out at £36.8m. We’ll use that as an example.
Whilst free cash flow hasn’t been steadily growing, net income and revenues have. Slow and steady wins the race. Because of the nature of this business, it seems reasonable to assume Dignity can continue these rates of growth for the next ten years. We’ll use net income growth as our determiner in this case. As ever, and probably somewhat underselling the prospects of the business, we’ll assume growth slows to 3% in perpetuity after these ten years.
Now the interesting bit. We’ll use a discount rate of 10%. This is an arbitrary figure, but one I usually start with when doing a DCF. Think of it as the return I want on this investment as an exchange for me allocating my capital here.
At present, the share price of Dignity PLC is £22.40.
Plugging all these figures into a DCF calculation gives an intrinsic value of £19.69. By these measures, Dignity does not warrant investment at this point in time.
However, in a world where risk-free rates are so low, what happens when we drop our discount rate to 8%? After all, an 8% annual return would still be impressive given the anaemic state of returns on cash and bonds.
Leaving everything else as it is, the intrinsic value of Dignity at an 8% discount rate is £29.02. It now appears a more viable investment.
Are Stocks Cheaper?
This is of course an abridged illustration of the power of the discount rate when looking at a valuation. As with all elements in a DCF, the discount rate is subjective and based on what return you want on equities for taking the added risk of holding them. Stocks can indeed appear cheaper if we reduce our required return. Whether you want to do that is up to you.
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