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DCF


JBird

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1) When you calculate intrinsic value, assuming it's by DCF, generally how many years out do you project owner earnings? When, if ever, do you project into perpetuity?

 

2) How do you decide the appropriate discount rate? Do you ever factor in a change of the risk-free rate over time?

 

3) If your projection of earnings goes for, say 10 years, Year 11 and beyond are "out" years. How do you deal with the valuation of Year 11 and beyond? Do you apply a terminal multiple, value all future cash at zero, etc.?

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1) When you calculate intrinsic value, assuming it's by DCF, generally how many years out do you project owner earnings? When, if ever, do you project into perpetuity?

 

2) How do you decide the appropriate discount rate? Do you ever factor in a change of the risk-free rate over time?

 

3) If your projection of earnings goes for, say 10 years, Year 11 and beyond are "out" years. How do you deal with the valuation of Year 11 and beyond? Do you apply a terminal multiple, value all future cash at zero, etc.?

 

I usually don’t do anything of that sort… Instead, when I believe FCF is the right metric to evaluate a company, I look back at past years: how fast has FCF per share grown in the last 10-year period? 15%? Very good! Then I try to answer this question: will it keep growing at the same rate for the next 10-15 years? Ok, very hard question to answer… But you must study the business and do your homework, right? Finally, will the P/FCF multiple stay the same 10 years from now? If the P/FCF is in between 10 and 15, and the company keeps growing FCF at a 15% annual rate, there is no reason why the P/FCF multiple should contract in the future.

 

Result: I buy a company that is selling at 13xFCF per share, which will grow FCF per share at a 15% annual rate for the next 10 years, and will still be trading around 13xFCF per share in year 11: 15% CAGR in the value of my investment for the next 10 years. :)

 

giofranchi

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I agree with gio...which I believe is what Alice Schroeder said that Warren Buffett did for one of his early investments.

 

He would look at the company, it's historical financials, the competitive environment, etc. and say, "Do I think this company can make 15% next year?"

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For me....discount rate is "hurdle rate". I want to make greater than 10% on my investments, so I use a 10% or greater discount rate. I also calculate it using higher discount rates, like 11-15%. If the 15% discounted value is less than Market Value, obviously it is a better value than something that is only undervalued at lower discount rates.

 

 

I project cash flows for like 40 years and put a terminal value on it. My method is very simple, because I don't know more sophisticated methods of valuation. I start with an FCFF, and project growth at a conservative rate. So if Google is growing at 15% annually, I model it at growing at 7% annually declining to like 4% into perpetuity. (And it still came out undervalued! LMAO)

 

I find that my valuation method is useful for my personal investments, but it is not sophisticated enough to impress professional fund managers in job interviews.  :-[

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