David is CEO of New Constructs (www.newconstructs.com), an independent research that specializes in unearthing key insights from the Financial Footnotes of Annual Reports. Having analyzed over 50,000 annual reports and their Financial Footnotes, New Constructs research regularly produces Hidden... More
How New Constructs' Discounted Cash Flow Model Works 2 comments
Aug 9, 2013 10:44 AM
Per How to Make Money Picking Stocks, our models focus on quantifying the expectations for future cash flows embedded in the market price or any target price. Our goal is to help clients identify and measure differences between their expectations for future cash flows and the market's expectations.
This post explains how we use our dynamic discounted cash flow model to quantify expectations for future cash flows.
In Figure 1, we compare bond valuation with stock valuation to show how the relevant terms correspond to each other. Equity cash flows, for example, mirror fixed income coupon payments. The Growth Appreciation Period for stocks is analogous to the maturity date for bonds. Market risk for bond investors comes from interest rate fluctuation. Market risk for equity investors is quantified by the Weighted-Average Cost of Capital (OTC:WACC), which quantifies the risk assigned to the stream of cash flows.
The key difference between bond and equity valuation is that equity value drivers are based on expectations, rather than defined by contracts.
Figure 1: The Basic Valuation Recipe - Same for Bonds and Stocks and Every Asset
(click to enlarge)
Source: New Constructs, LLC
We can extend the framework to demonstrate more detailed financial analysis. Figure 2 shows how business cash flows can be broken down into more intuitive financial terms like Revenue Growth and Return on Invested Capital (NASDAQ:ROIC).
Figure 2: The Key Ingredients of the Valuation Recipe
(click to enlarge)
Source: New Constructs, LLC
Using Intuitive Terms
We can replace the cash flow variable and focus on the three variables with which investors are most familiar. We can use these three terms to quantify the specific financial performance required to justify stock prices for all companies:
Figure 3: The Valuation Recipe - Key Value Drivers
(click to enlarge)
Source: New Constructs, LLC
New Constructs' discounted cash flow model calculates the value attributable to stock prices based on the forecasted financial performance entered into the model. The model harnesses state-of-the-art computing power to calculate a value per share for every year up to 100 years into the future. We do not believe that we can forecast the future performance of a company into the future with any special accuracy. Our model focuses on the market's expectations for future financial performance by matching the market price of a stock with values calculated by the DCF model. In turn, we leverage our model to tease out of the stock price the stock market's expectations for the future financial performance of a company. This insight enables investors to calibrate their valuation assessment around the market's expectations. The burden of predicting the specific performance of the core value drivers shifts to the market. Investors only can determine whether they feel market expectations are too high, too low, or about right.
Terminal Value Assumptions
The key difference between our DCF and others is that we calculate the value attributable to equity shareholders over multiple (100) different time periods. In addition, our yearly calculations represent different Growth Appreciation Periods (GAPS) because they are based on a Terminal Value that assumes the company generates no future incremental profits. To be specific, our Terminal Value for each annual calculation is a perpetuity calculation that assumes no future growth after each GAP. The formula is NOPAT_{t+1} divided by WACC. Using a Terminal Value that assumes no future profit growth enables our DCF model to calculate the specific value of companies implied by each Growth Appreciation Period.
See Figure 4 for a graphic representation of how our model's dynamic discounted cash flow analysis calculates the value of a business and the attendant value available to shareholders for multiple Growth Appreciation Periods. This chart shows how the value of the company analyzed in this example rises as its Growth Appreciation Period increases. The 'Market Implied GAP' equals the Market-Implied Growth Appreciation Period implied by the current market price. Our model calculates the 'Market Implied GAP' by matching the current stock price with the year that the DCF value matches that of the current stock price. For example, the 'Market Implied GAP' for the company in Figure 4 is 16 years. Our model can also calculate the GAP implied for target prices as well as any other stock prices no matter how great or small they may be. The analysis in Figure 4 shows DCF values for only 35 years though the model values companies for 100 years into the future.
Figure 4: Results of the Dynamic Discounted Cash Flow Calculations: Company Models calculate the GAP implied by the current stock price
(click to enlarge)
Source: New Constructs, LLC
Figure 5 shows the summary info on the Decision Page in every one of our 3000+ models.
Figure 5: Decision Page provide summary of the discounted Cash Flow analysis
(click to enlarge)
Source: New Constructs, LLC
Figure 6 below, presents a copy of the DCF model used to generate the values in Figures 4 and 5.
Figure 6 also shows how our DCF model calculates values for multiple forecast horizons or Growth Appreciation Periods. These values provide the data needed to generate a chart like the one above and like the valuation matrix as presented on the Company Model Decision Page. Note the highlighted sections in Figure 6 and how they jibe exactly with the Revenue CAGRs, Economic Earnings Margin, and GAPs presented in Figures 4 and 5.
Figure 6: Sample Dynamic Discounted Cash Flow Model for Sample Company
Instablogs are blogs which are instantly set up and networked within the Seeking Alpha
community. Instablog posts are not selected, edited or screened by Seeking Alpha editors,
in contrast to contributors' articles.
Hi David - Thanks for providing this information. I have found your articles to be a great learning source.
I'd like to take a detailed look at Figure 6 but the format you provided is not clear enough to read even if I zoom in. Could you upload another version?
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.
How New Constructs' Discounted Cash Flow Model Works 2 comments
Per How to Make Money Picking Stocks, our models focus on quantifying the expectations for future cash flows embedded in the market price or any target price. Our goal is to help clients identify and measure differences between their expectations for future cash flows and the market's expectations.
This post explains how we use our dynamic discounted cash flow model to quantify expectations for future cash flows.
In Figure 1, we compare bond valuation with stock valuation to show how the relevant terms correspond to each other. Equity cash flows, for example, mirror fixed income coupon payments. The Growth Appreciation Period for stocks is analogous to the maturity date for bonds. Market risk for bond investors comes from interest rate fluctuation. Market risk for equity investors is quantified by the Weighted-Average Cost of Capital (OTC:WACC), which quantifies the risk assigned to the stream of cash flows.
The key difference between bond and equity valuation is that equity value drivers are based on expectations, rather than defined by contracts.
We can extend the framework to demonstrate more detailed financial analysis. Figure 2 shows how business cash flows can be broken down into more intuitive financial terms like Revenue Growth and Return on Invested Capital (NASDAQ:ROIC).
Using Intuitive Terms
We can replace the cash flow variable and focus on the three variables with which investors are most familiar. We can use these three terms to quantify the specific financial performance required to justify stock prices for all companies:
New Constructs' discounted cash flow model calculates the value attributable to stock prices based on the forecasted financial performance entered into the model. The model harnesses state-of-the-art computing power to calculate a value per share for every year up to 100 years into the future. We do not believe that we can forecast the future performance of a company into the future with any special accuracy. Our model focuses on the market's expectations for future financial performance by matching the market price of a stock with values calculated by the DCF model. In turn, we leverage our model to tease out of the stock price the stock market's expectations for the future financial performance of a company. This insight enables investors to calibrate their valuation assessment around the market's expectations. The burden of predicting the specific performance of the core value drivers shifts to the market. Investors only can determine whether they feel market expectations are too high, too low, or about right.
Terminal Value Assumptions
The key difference between our DCF and others is that we calculate the value attributable to equity shareholders over multiple (100) different time periods. In addition, our yearly calculations represent different Growth Appreciation Periods (GAPS) because they are based on a Terminal Value that assumes the company generates no future incremental profits. To be specific, our Terminal Value for each annual calculation is a perpetuity calculation that assumes no future growth after each GAP. The formula is NOPAT_{t+1} divided by WACC. Using a Terminal Value that assumes no future profit growth enables our DCF model to calculate the specific value of companies implied by each Growth Appreciation Period.
See Figure 4 for a graphic representation of how our model's dynamic discounted cash flow analysis calculates the value of a business and the attendant value available to shareholders for multiple Growth Appreciation Periods. This chart shows how the value of the company analyzed in this example rises as its Growth Appreciation Period increases. The 'Market Implied GAP' equals the Market-Implied Growth Appreciation Period implied by the current market price. Our model calculates the 'Market Implied GAP' by matching the current stock price with the year that the DCF value matches that of the current stock price. For example, the 'Market Implied GAP' for the company in Figure 4 is 16 years. Our model can also calculate the GAP implied for target prices as well as any other stock prices no matter how great or small they may be. The analysis in Figure 4 shows DCF values for only 35 years though the model values companies for 100 years into the future.
Figure 5 shows the summary info on the Decision Page in every one of our 3000+ models.
Figure 6 below, presents a copy of the DCF model used to generate the values in Figures 4 and 5.
Figure 6 also shows how our DCF model calculates values for multiple forecast horizons or Growth Appreciation Periods. These values provide the data needed to generate a chart like the one above and like the valuation matrix as presented on the Company Model Decision Page. Note the highlighted sections in Figure 6 and how they jibe exactly with the Revenue CAGRs, Economic Earnings Margin, and GAPs presented in Figures 4 and 5.
Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.
Share this Instablog with a colleague