- Free Cash Flow forecasting & Discounted Cash Flow analysis can provide an invaluable look into firm performance and primary drivers.
- An in-depth DCF valuation prior to entering a long (or short) position can greatly improve probability of investing success.
- DCF analysis will require time and practice to perfect; it is more of an art than a science.
FCFE DCF Valuation
My preferred method of firm valuation includes a 10-year forecast of Free Cash Flow to Equity (FCFE) and resulting Discounted Cash Flow (NYSE:DCF) valuation in tandem with estimated cost of equity and terminal growth values.
This process involves a number of steps and includes both quantitative & qualitative fundamental analysis. The steps are as follows:
- Gather fundamental financial data from most recent annual/quarterly reports to do an initial financial-health analysis. This includes share price, market cap, equity, debt, liquidity ratios, and various valuation metrics.
- Dive into qualitative aspects behind the business. How has the business driven growth in the past? What is managements' approach toward driving growth & innovation in the future? How will management respond to industry competition? What are the primary business-risks and how are they being hedged? Where are the primary business-opportunities and how are they being leveraged? etc.
- Model past 5 years of financials from the Income Statement (IS), Balance Sheet (BS), and Statement of Cash Flows (SCF). Include a ratio & trend analysis comparing figures to the most relevant drivers. For instance, I will typically compare Inventory on the BS to Revenue on the IS to see how the trend has changed over time. Additionally, I like looking at the change in liquidity & efficiency ratios over time in hopes that the firm is improving upon their operations.
- Compile a 10-year forecast of each financial statement based on my historical trend analysis in conjunction with qualitative and quantitative information gathered from SEC filings and investor presentations/press releases. This is the portion of the valuation with the most uncertainty due to multiple assumptions being made. However, this is also the portion that allows an individual to really dive into the valuation and make their mark based on all of the research & studying they've completed. Spend ample time on a revenue & expense model. This should be broken down into individual business segments to provide the most granularity.
- Calculate FCFE based on the forecasted financial results. I calculate FCFE as Net Income - Change in Working Capital - Net Capital Expenditures + New Debt.
- Estimate a terminal growth rate & cost of firm equity to be used in the DCF portion of the analysis. I typically look at industry peers, market/global environment and product diversification to estimate these values. For instance, a firm selling one product to one or two customers will require a much higher cost of equity (discount rate) due to future uncertainty.
- Apply the cost of equity and terminal growth rate to the free cash flows to complete the DCF valuation. This will produce the "value of a firms equity" which can be divided by shares outstanding resulting in the valuations price per share.
At this point, the DCF valuation is superficially complete. However, I ALWAYS build in scenario and sensitivity analysis to my valuations. For instance, I will revisit my assumptions phase, and recreate my revenue and expense models for a bull and bear case (as opposed to the "base" case we just created). Additionally, I will perform a sensitivity analysis for Cost of Equity and Terminal Growth Rate. In conjunction, these steps will give you a view at resulting share prices under a large number of different conditions.