POST OF THE DAY
Foolish Collective
Quick DCF Step by Step

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By sleejohnson
September 11, 2003

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

Just for fun, I thought I'd describe in detail the process I use to generate a "quick and dirty" valuation of a company before I invest a lot of time and effort in evaluating the company. This is basically a very preliminary discounted cash flow valuation using data readily available on the Web.

I'll use PAYX as an example. This is the basic Yahoo! quote page for PAYX:

http://finance.yahoo.com/q?s=payx

I'll click on "Key Statistics" in the left column to go to this page:

http://finance.yahoo.com/q/ks?s=PAYX

Writing down notes as I go (so I can refer to them later to see if anything has changed), I see that PAYX had $7.64 cash per share and no debt as of the most recent quarter. If PAYX had debt, I'd multiply book value per share ($2.86) times "Total Debt/ Equity" (here it is 0.00) and subtract the result from $7.64. I'll also note that the regression Beta for PAYX is 0.753 (near the top of the right hand column). Finally, I'll note that PAYX's fiscal year ended 5-31-03. Now I'll click on "Analyst Estimate" (left column) to go to this page:

http://finance.yahoo.com/q/ae?s=PAYX

Current year EPS estimate is $0.85. This will be the initial amount that I'll use in my DCF. I'll use EPS instead of trying to calculate cash flow because it's easier. I'll use current year projected EPS instead of trailing twelve months EPS because that is more likely to be representative of what analysts think PAYX's 'normalized' earnings are. TTM earnings can be unduly affected by one-time gains/losses. If this was late in PAYX's fiscal year, I might use analysts estimates for NEXT YEAR'S earnings, instead. But the new year just began on 6-1-03, so I'll start with 0.85. But interest earnings on the $7.64 cash will account for about 0.19 of earnings (7.64 * .025 to estimate after-tax interest). So the starting EPS I will use is 0.66.

At the bottom of the page, I see analysts are expecting 18% earnings growth over the next 5 years. I now have all the information I need for my quick and dirty valuation.

Turning back to the DCF tool:

http://www.creativeacademics.com/finance/dcf.html

I plug 0.66 in the first box (Cash Flow).

For Discount Rate, you can use the same rate for all companies (e.g., 15% or 12%) or you can calculate a discount rate based on the regression beta. Because I already have the beta (0.753), I'll use that to determine the discount rate as follows:

5.50 (risk free rate) + 0.753(6.50) = 10.4%

For Cash Flow Growth, I'll start with analyst estimates of 18% for 5 years. For subsequent years, I assume that the growth rate will decline in steps to the terminal growth rate (I use 3% for terminal growth). I do this by taking the average of the previous 5 years growth rate and the terminal growth rate: (18 + 3)/2 = 10.5. I usually round down to the nearest whole %, so the second 5 years will grow at 10%. Then (10 + 3)/2 = 6.5% or 6%. Then (6 + 3)/2 = 4.5%, which I will just reduce to the terminal rate of 3%.

If you read the instructions for this DCF tool, you'll see that the syntax for 18% growth for 5 years, followed by 10% growth for 5 years, followed by 6% growth for 5 years, followed by 3% terminal growth is:

18|5:10|5:6|5:3

This results in a Present Value of $22.88. Add in $7.64 cash per share and you get a value of $30.52 compared to PAYX's current price of about $36/share.

Now, this is not what I consider to be a "conservative" DCF for a number of reasons. Using analyst's estimated 18% growth is quite generous (analysts on average overestimate 5 year growth rates). Using estimated EPS as a substitute for FCF is probably generous, especially when used with these high growth rates. The discount rate is close to my minimum (10%) and I'm not sure yet that PAYX deserves such a low discount rate. Changes that I might make later will most likely lead to a lower valuation. And this value does not include any margin of safety other than the 4.9% equity risk premium (0.753 * 6.5%) I used in the discount rate. Consequently, I can say with some confidence that it is not likely that I would be willing to pay more than about $22/share for PAYX at the present time. Because that is almost 40% below PAYX's current price, I wouldn't spend much time researching PAYX beyond putting it in a tracking portfolio just to keep up to date.

This is merely a screening tool; you can cut some of these steps out for the sake of simplicity. Simplicity is, after all, one of the main virtues of a screening tool. I just wanted to illustrate some of the nuances I sometimes use when using this method to screen stocks.

Slee


Become a Complete Fool
Join the best community on the web! Becoming a full member of the Fool Community is easy, takes just a minute, and is very inexpensive.