Wednesday, May 12, 2010

Simplified DCF

The concept of discounted cash flow brings a certain appearance of sanity to the process of asset valuation. Every person/site that explains this concept always gives a caveat about the fact that DCF cannot be used in isolation and needs to be used in conjunction with other factors such as book value, growth rate (though this could be factored into DCF calculation), market penetration, market size and even more intangible factors such as market mood, management strength and else.

I once read that Warren Buffet could tell you in a few minutes of hearing about a company if it is deeply undervalued/discounted at current market price. This is a price at which you would be a moron to not buy it. After reading about this (and I was investigating DCF at that time) I have come up with a model of my own. Though you will find that this calculation is rather aggressive I think there is something to it if you are looking for deep value. How do I know you ask? Well I had done this calculation for a number of companies sometime in 2007 and at that time the numbers that I came up with were almost half of the current value. But following the crash of 2008 most of the companies bottomed out in and around the numbers that I had computed. So I have some renewed confidence in this calculation. Unfortunately these will be numbers that you will not see in today's market but you can always recognize value when you see it.

So in this simplified calculation, for every 5% growth rate over a period of 5 years I add 1 to 8.5 (which is the base multiple) and the resultant value is the multiple of annual EPS that should determine the current market price. These numbers come from doing multiple DCF calculations for multiple companies and observing a pattern.

So if you have a company with an annual EPS of 2$ and a 5 year growth rate of 10% then the "deep value" price is 10.5*2 = 21$. Having said this I always discount the growth rate a few point from the projections especially for high growth companies.

In 2007 this calculation yielded a 250$ value for GOOG. I believe GOOG bottomed out in the low 220s. This was the case for a few other companies that I was following.

Now I too have a way of telling if a company is deeply undervalued and if there is a buffer in the price I am paying for a stock.

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