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

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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]