Chapter 3: The Discounted Cash Flow Model
Summary: you will learn how the discounted cash flow model works and start adding data to the model.
DCF Model Steps
We defined a valuation method as “a set of steps used to determine how much a stock is worth.” We then noted this program will use value investing principles to value stocks. Warren Buffett, one of the great value investors, shared the steps he takes to value a company: “To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate.” Sounds simple enough?
Calculate the company’s free cash flow from now until eternity.
Choose an “appropriate” discount rate.
Discount the free cash flows back to the “present”.
Open the Model
Let’s see these steps in action. In your model, go to the ‘DCF Basics’ tab.
This page is very basic - it is the bare bones version of the ‘Discounted Cash Flow Model’ tab. This tab is just for education purposes and doesn’t affect the file in any way, we can actually delete this tab after we’re done with it.
Let’s look at the very top of the page, rows 1 and 2. We have 300 columns, each representing one year in the future. Remember that we need to calculate a company’s free cash flow from now until eternity. For simplicity, let’s just do the next 300 years, you’ll see why we don’t need to go further than that.
In row 3, we have free cash flow. Because we are valuing Apple’s stock, we have Apple’s free cash flows. In Cell B3, this is Apple’s actual 2022 free cash flow. I know by now you’re dying to know what free cash flow means. We’ll provide a quick tease of what it means now, but we’re going to learn all about it in the next chapter.
Free Cash Flow Introduction
Free cash flow is just a fancy name for cash. I’m sure you were expecting some crazy formulas for how to calculate free cash flow, but here it is:
Free Cash Flow = how much cash a company makes.
Let’s say Apple sells an iPhone to a customer for $1,000. And it costs $700 for Apple to make an iPhone. That means Apple made $300 in cash from that purchase.
We will dive into this topic a lot more next chapter. For now, all you need to know is that free cash flow is simply the amount of cash a company makes from selling its products or services.
Going back to Cell B3, we see the number in the cell is $100,533,000,000. Apple made $100.5 billion in cash (free cash flow) in 2022.
Before we move on, we should appreciate how much money $100 billion is. It really is an insane amount of cash. Let’s look at how Apple makes $100 billion in cash every year:
Apple sells iPhones, Macs, iPads, accessories like AirPods, and services like App Store fees and Apple TV subscriptions.
According to industry sources, Apple sells about 300 million devices like iPhones and Macs each year.
Apple sells these devices for around $1,000 on average. Macbooks sells for more on average ($1,000-$2,000) and iPads sells for less on average ($500). But on average, these 300 million devices sell for $1,000 per device.
Apple’s revenue is therefore 300 million * $1,000, which is $300 billion. That is just for devices. Apple also sells an additional $100 billion in accessories and services. So Apple’s total revenue is $400 billion per year.
On average, Apple’s profit margin is 30%. For every $1 Apple makes, 70 cents goes to expenses like iPhone parts and employee salaries, and Apple keeps the remaining 30 cents as profit.
$400 billion in revenue * 30% profit margin = $120 billion in cash.
Apple then pays a 15% tax rate, which is about $20 billion a year in taxes. Apple pays these taxes just like us, in cash to the government.
$120 billion cash from profits minus $20 billion in taxes gets us to $100 billion in cash.
That was Apple’s business explained very simply. We are going to do a deep dive into Apple’s business model in future chapters. The only thing you need to know now is that Apple makes a ton of money, about $100 billion each year. Specifically for 2022, they made $100.5 billion.
Step 1: Calculate Future Cash Flow
Let’s remember the steps for our valuation method again:
Calculate the company’s free cash flow from now until eternity.
Choose an “appropriate” discount rate.
Discount the free cash flows back to the “present”.
We know Apple made $100.5 billion in cash for 2022, but how do we know how much they expect to make?
That is the purpose of the discounted cash flow model, to predict this. We are going to spend a lot of time on this so for now, let’s just simplify it.
For simplicity, we are going to project that Apple will grows it free cash flow 3% every year from 2023 until the year 2300. I know it sounds ridiculous. But you’ll see soon why it makes sense.
By projecting a 3% growth rate in free cash flow, we can add a simple formula to project free cash flow for the next 300 years, as seen in the screenshot above.
If we increase the free cash flow by 3% for 300 years, we can see in Cell KP3 that we end up with $713 trillion for Apple’s free cash flow in the year 2322, only 300 years from now. Again, I know this sounds ridiculous but hang in there.
Step 2: Choose Discount Rate
We are now on to Step 2. The only goal of Step 2 is to populate the discount rate which lives in row 4 of the model.
To understand discount rates, let’s look at a few examples.
Your best friend asks for a $100 loan. Your friend says they will pay back the $100 in 365 days but without any interest. Would you do it?
You’re at the grocery store and a random stranger asks for $100. They also say they’ll pay you back in a year but can’t afford to pay any interest on it. Would you do it?
Your uncle asks for a $100 loan and says he’ll pay back $5 each year for the next 20 years. What do you think?
These are some of the questions you may be asking yourself when reading these questions:
How likely is that each person will pay me back?
What happens if they never pay me back?
What about inflation?
What if the amounts changed? Instead of $100 they were asking for $20,000?
Could I use the money in a better way? Like paying bills or buying a new car?
This is what a discount rate is all about. We saw in Step 1 that if Apple grew its free cash flow by 3% for 300 years, their free cash flow would be $713 trillion. As a shareholder in Apple, you would be entitled to receive part of that profit. The question is, what does money 300 years from now do for you? The answer is: nothing.
So a discount rate is used to account for the fact the further away a promise of money is made, the less valuable it is to us. Future money is less valuable than money given to us today because future money: has the risk of not be paid back, ends up being worth less if inflation goes up, and could be invested in better ways.
So how we do decide the “appropriate” discount rate that Warren Buffett mentions?
In short, it depends on current and future interest rates. A government bond is considered ‘risk-free’ because investors believe there is an almost 100% chance the US government will not default on its debt anytime soon. The current 10-year treasury bond is 3.5%, meaning you are nearly guaranteed to earn 3.5% per year on every dollar you invest in US treasury bonds.
So if you’re guaranteed to earn 3.5% on that investment, you surely wouldn’t accept a riskier investment for a promised return less than 3.5%.
To account for all of these factors, we generally use a discount rate around 10%. We see Row 4 of the model is already populated with the 10% discount rate, so let’s look at the effects of a 10% interest rate.
Step 3: Discount the Cash Flows
Congratulations on reaching the last step of our valuation method. This step is a lot easier to understand as there is no theory behind it, just math.