Valuing Stocks using Discounted Cash Flows

The Basic Issue

First see how these stock valuation methods fit into the possible investing strategies discussed on the Big Picture Strategy page. This methodology for valuing PROJECTS is very powerful. It has three basic inputs; the cash flow dollars, the timing of those cash flows and the rate of return demanded. But there are more than a few problems when trying to use it for valuing stocks.

• The model has no inputs for dilutions of ownership percentages. It is never calculated on a ‘per-share’ basis. When shares are issued and bought-back, or when options are used for compensation, the stock owner’s percentage ownership of the whole changes.
• The model presumes receipt and benefit from all the cash flows. That may be true of the stock’s purchase and sale price and its dividends. But what about companies which pay no dividends? Then the eventual sale price becomes the dominant factor in the stock’s valuation. When the current stock value is derived from the future resale price, any assumptions become self-justifying.
• The model has no inputs for non-cash barter transactions.
• As this methodology has gained popularity, so too management has finessed analysts by hiding the company’s problems in these ignored transactions.
• There remains the huge problem of defining exactly “what” cash flow. For a directly owned project, all cash generated is under the control of owners and available to them (the total change in cash = the first column of the diagram below). But shareholders have no control over a company’s cash.

The Original Discounted Dividend Model

Users of the Discounted Dividend Model think that the only value to investors from shares is the actual cash they receive from the company. The original models considered only dividends because at that time most companies paid out all the profits they could. The methodology ignores cash profits that are reinvested (Retained Earnings). Instead, users integrate a projected growth rate for the dividends. This spreadsheet shows the model’s calculation.

Share Buybacks theoretically impact investors the same as dividends. So when capitalizing the cash flows to determine a stock price, it might be appropriate to include these. That is often done now. Unfortunately, a large portion of stock buybacks only sop up new shares issued by the company to employees exercising stock options. Net/net there was no reduction in shares outstanding. Only the cash cost of net reductions should be capitalized as quasi-dividends.

There is also a problem with the presumption that the cash used for buy backs has the same kind of sustainability as normal dividends.

• There is no market expectation or management commitment that the buy backs will continue. The market only finds out in hindsight that they have occurred.
• The shares repurchased may be kept in treasury and reissued at a later date. These purchases would be better considered a financing maneuvre, than a return to shareholders.
• The buy backs may NOT result in the theoretical increase in share price. Investors have no ability to monatize their ‘return’ by selling the shares.

Earnings Retained are, quite correctly, never included in any of the discounted cash flow models. Some profits must always be retained to counter the ravages of inflation. For example, when sales increase due to price inflation, the amount sitting uncollected in Accounts Receivable grows by the inflation rate, and needs to be financed.

It is the Retained Earnings that finance real growth (after inflation) as well. The cash can be used to buy other businesses or to expand production facilities or to advertise in new markets. All the discounted cash flow models include some presumed growth rate into the future. Since dividends today provide only 2% or 3% returns, the remaining 7% or 8% (of investors’ demanded 10% return for common share risk) must come from growth.

The rate of growth is dependant on

• factors external to the company in the economy and industry,
• changes to the company’s leverage with debt,
• the proportion of earnings retained and
• the incremental rate of return the company can earn from their reinvestment.

Conclusion: The spreadsheet shows that the discounted dividend model is conceptually very close to stock valuations using P/E’s. Both rely on the same piece of the total cash flow – the accounting earnings. While the dividend model capitalizes only the dividends, it incorporates the retained earnings within its growth assumption. The P/E model capitalizes all the accounting earnings but adjusts the multiple for higher/lower growth (predicted by incremental ROE).

The problem remains that the models are more dependant on the growth assumptions than on the actual dividend. And how can you value a company that pays no dividends?

Discounted Cash Flow using Cash From Operations or Free Cash Flow

Newer models for determining stock values address the issue of growth by modeling the company’s accounting line-items year by year for the period of expected high-growth. One model is presented by Aswath Damodaran on this spreadsheet. (scroll to top of its page). His book detailing the method is published online from this directory.

1. For each high-growth year the expected net cash increase/decrease is calculated. The cash flow measured includes all the costs of growth, not just maintenance.
   • Net Income (Warning! other models start from other points and will therefore have other adjusting entries.)
   • less increases to working capital
   • plus new debt financing received
   • less debt principal repaid
   • less purchases of fixed assets for growth and maintenance
   • plus (reverse out) depreciation and amortization
2. Each year’s cash is discounted back to the present.
3. The value of the stock at the end of the high-growth phase is derived using the more basic P/E or Discounted Dividend models. This is also discounted to the present.

You can see how different his model is from stock analysts’ glib capitalizing the current year’s Cash Flow From Operations (CFFO – the second column of the diagram, or the top section of the Statement of Cash Flow). He tries to measure what is called Free Cash Flow. Everyone has their own definition of Free Cash Flow. Often the CFFO is simply re-named. Other times its determination includes overly optimistic estimates. Most often you see it calculated WITHOUT the cost of growth investments.

Stocks should never be valued by capitalizing CFFO. That means you divided the CFFO by your required rate of return to give the asset’s value. In the diagram you can see that Earnings are a much smaller part of CFFO. They are only a sub-set of CFFO. Any valuation based on CFFO will necessarily be a lot larger than one based on Earnings, and a LOT larger than one based on only Dividends (a sub-set of a sub-set of CFFO).

Damodaran’s model shows how his Free Cash Flow is predicted to be less than Earnings.

• Investment in Net Current Assets is necessary for growth, even if the growth is due only to inflation. It is most common to see the current quarter/year’s change in current assets used as if it is a ‘normalized’ value. In fact there are large swings from quarter to quarter, year to year, even though over the longer term the funding level is stable for a given level of sales. For example, in good times a company will pay its suppliers faster than normal to build up some goodwill for the bad times.Take out of your analysis of net current assets cash, current portion of long-term-debt and bank debt. It is cash you are trying to measure and the debt is handled separately.
• Net Financing Received equals the net excess of new debt proceeds over any repayments. Companies most often keep their debt-to-equity ratios stable, so growth is financed by a combination of retained earnings and net new debt. Too often investors subtract the required debt repayments from CFFO in their calculation of Free Cash Flow, ignoring new debt. This ignores the reality that company’s debt balance is rarely reduced. It is replaced. With operating growth, debt will probably grow too.
• Damodaran reduces his estimate of Free Cash Flow by the expected long-run replacement costs of fixed assets (showing in the diagram as Cash Used for Long-Term Investments). Notice how his estimates are LARGER than the depreciation booked. You will almost never see an analyst making that assumption.
• Depreciation is correctly added back to Net Income in everyone’s calculation of cash flows. It is an allocation of the original purchase price over time. But that does not mean it has no economic reality. All assets (except land) wear out, or become obsolete. In order to protect the sustainability of dividends assets must eventually be replaced.
• Historical cost basis
• Forward looking basis
• Opportunity cost basis.
• buy and pay cash for the asset
• borrow money to buy the asset, repaying the principal and interest over its life
• lease the asset.
• the purchase price of the asset is not ‘expensed’ at the time.
• at the end of the asset’s life, the companies have no asset and no debt
• the ‘cash cost’ of the asset is recognized as it is use; either as depreciation or as lease payments.

Conclusion

While discounted cash flow analysis is an excellent methodology for evaluating projects over which you have complete control, for valuing common stock it is full of problems. What measure of cash flow do you use: Earnings, Dividends, CFFO or Free Cash Flow?

For companies without large dividends the company’s value lies in its growth. Investors have tried to develop measures of ‘the cash that COULD HAVE been paid out as dividends if it had not been reinvested instead’. Too often these attempts ignore the investments necessary for growth. While analysts will quote cash flows larger than reported Earnings, academics show that Free Cash is much less than Earnings when the company is growing.

Retail investors must appreciate that correctly derived Free Cash Flow involves a lot of time and industry knowledge, which they probably do not have. Maybe using the traditional valuation metrics are not a bad idea.

• Price / Earnings
• Price to Book
• Price to Sales
• Dividend Yield