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

The DIY Investing Podcast: Value Investing | Fundamental Analysis | Mental Models | Business Management

Release Date: 05/19/2019

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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