ALEXANDRIA, VA (Sept. 14, 1999) -- Running a discounted cash flow model on a company is easier than you might think. We have done so in the past, and we will do so again in the future, including... today!

A discounted cash flow model is not a magic formula that spits out the guaranteed, no-questions-asked, fair value of a company. However, by setting expectations that prove realistic and then projecting them forward, you can generally estimate how much you should pay for a stock when you hope to achieve a specific long-term rate of return (a return that you can call your hurdle rate, and which typically will match your discount rate).

The Drip Port's desired annualized rate of return is at least 15.5%, which handily stomps the S&P 500's 11% historic average. This goal is aggressive for a portfolio that dollar cost averages, but is not impossible provided that we have both Foolish skill and luck (which Brian holds in spades, along with a touch of insanity).

Having spent much of the past two weeks on Wrigley (NYSE: WWY), let's dive into the company's valuation according to a discounted cash flow (DCF) model.

To lure the DCF beast from its lair to come out and play, we need a few essential "treats." Specifically, we need the company's return on equity, its dividend payout ratio, its free cash flow (with Wrigley we're using net operating profit after taxes, or NOPAT, because it mirrors free cash flow), and we need to decide on our discount rate.

We compiled Wrigley's return on equity figures on Friday:

 Return on Average Equity (ROE)
1998 28.4% 1997 28.9% 1996 27.2% 1995 30.1% 1994 36.5% 1993 32.6% 1992 29.4% 1991 29.8% Average 30.3%
Wrigley's average ROE over the past eight years is 30.3%, so we'll use that. How do we use ROE? ROE can be multiplied by one minus a company's dividend payout ratio to approximate the company's future rate of earnings growth. If Wrigley's ROE averages 30.3% in the future, and if the dividend payout ratio continues to stick to around 50.0% (0.50) -- which is where Wrigley tries to keep it -- we do the following math:

1 - 0.50 = 0.50 x 30.3 = 15.15%.

According to this simple but useful formula, we could hope for average earnings per share (EPS) growth of 15.15% annually. Beautiful. Very close to our goal. Buy the stock, slap on a price premium, and we're all set.

Ah, if only it were that easy.

Instead, I'd like to temper that growth rate, then see how much of the company's potential growth is already factored into the stock price. To find the discounted value of the company's annual cash flow, we divide Wrigley's NOPAT by our discount rate, and then we square the discount rate by an additional factor for each additional year beyond one. Our discount rate is going to be 4.5% above the company's assumed cost of capital, or 15.5%. This is our rate of return goal, or hurdle rate, in the Drip Port.

In 1998, Wrigley had NOPAT of $2.42 per share, or $280,632,000. We'll assume 11% annual growth (matching the estimates) in Wrigley's NOPAT despite the 15.15% estimate provided by our simple calculation. 15.15% is just too aggressive an EPS growth rate for this company in the long run. Here we go...
($ in thousands)

Year     NOPAT           Value
1999   $311,501        $269,697
2000   $345,766        $261,448
2001   $383,801        $249,092
2002   $426,019        $239,387
2003   $472,881        $230,060
2004   $524,898        $221,097
2005   $582,636        $212,482
2006   $646,727        $204,204
2007   $717,867        $196,248
2008   $796,832        $188,602
$2.272 billion is the current value of the company's next 10 years of net operating profit after tax starting from last year's results and assuming 11% annual growth. To find the company's continuing value from year 2009, we divide year 2009's NOPAT by the difference between our discount rate (15.5%) and the company's growth rate from year 11 forward, which we continue to assume is 11%.

So, 2009's NOPAT is assumed to be $884,483. We divide that by 0.045, which is our discount rate (0.155) minus the assumed growth rate (0.11). Doing this math, we arrive at $19,655,178,000 in continuing value before discounting. Discounted at 15.5% to the tenth power, we arrive at $4,652,144,000 ($4.6 billion) in continuing value after year 10. Adding this to our first 10 year's of value, we have $6,924,144,000 ($6.9 billion) as the total price at which we would want to buy the company to achieve our desired 15.5% return.

With 116.1 million shares outstanding, we should pay $59.64 for the stock if we hope for a 15.5% annualized return and if we assume 11% annual NOPAT growth. Wrigley is priced at $77. At $77, Wrigley is trading at 29.3 times trailing earnings. At $59 per share, Wrigley would trade at its 10-year average P/E of 23. The low price target given by the model is not surprising nor even discouraging. A discount rate of 15.5% is high and will typically lead to a much lower target than the current share price.

Despite the price of the stock compared to the model's ideal price, we've said in the past that we are looking for stability from our food and beverage investment alongside market growth that is respectable. So, anything above an 11% annual return would be gravy. We aren't confident nor naive enough to believe that giant food companies can grow 15.5% annually for two decades. That would be downright amazing -- as amazing as Brian learning his ABC's before age sixteen. However, we do believe that a leading food and beverage investment can top the market by offering both stability and growth. After all, the S&P 500 is far from guaranteed to rise 11% annually over the next two decades, history or no history. But a well-chosen food leader could indeed rise at least 11% and offer stability in the process.

Tomorrow, we will again assume that Wrigley can grow 11% annually (the estimate for the next five years is 11.33%), but we'll lower our discount rate to perhaps 13% (which would still be an excellent return). We may also notch down our growth expectations after year 10 from 11% to 10%, just to be conservative. With these parameters, we'll see tomorrow what the DCF beast spits back at us as a fair value. To discuss these columns, please visit the Drip Companies message board.

Fool on!