Fair Value Analysis

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November 27, 2022
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In the last 3 posts, I presented some details on my investment process for downselecting equities for analysis and potential consideration for making an investment.  Stock down selection process for me is rather qualitative. However, to analyze the fair value of a given stock at any given point in time, requires some analysis and number crunching, easily done in excel if necessary.

In this article, I will present some details on a particular method of fair value analysis that I prefer to assess whether the stock is trading at a valuation that would make me excited.  The methodology is based on discounted cash flow (DCF) analysis, a simpler version of which is explained rather well in this Investopedia article.

The formula is reproduced here with some modifications,

\text{DCF} = \text{Excess Cash} + \frac{f_{0}(1+g)}{(1+r)}+\frac{f_{0}(1+g)^{2}}{(1+r)^{2}}+ \cdots + \frac{f_{0}(1+g)^{T}}{(1+r)^{T}} + \frac{\text{TV}}{(1+r)^{T}}

  • r : discount rate, also referred to by the technical name of “weighted average cost of capital”
  • g: growth rate (assuming constant growth)
  • f_{0}: Free cash flow at the end of last year
  • TV: Terminal value
  • T: The period under consideration for DCF before terminal value kicks in

The formula for terminal value is rather simple, as follows, TV_{T} = \frac{f_{0}(1+g)^{T+1}}{r-g}

And first-order estimates for discount rate can be obtained as follows: r = \beta \times (\text{average market returns}) + \text{risk-free rate}, where \beta measures the stock volatility relative to market volatility.

DCF equation looks rather hairy for the uninitiated but the idea behind DCF is rather simple. Any given firm’s present worth equates to the sum total of all future cash flow produced by the firm, discounted to the present day by the discount rate r.

The complication in using the DCF formula lies in the unknowns, which by definition are always unknowns (as they depend on the future playing out): assumed growth rate, g,  and the risk-free rate, which is typically the 10-year treasury rate.

If you look carefully at the formula again, the risk-free rate goes into the denominator of DCF, compounded by the duration into the future. As such, a small change in the risk-free rate can significantly impact the present value of the firm.

Warren Buffett appropriately compares risk-free rate (interest rate) to gravity and is quoted to say they “power everything in the economic universe”.

For people who wondered why the in-vogue growth stocks of last year– Shopify (ticker: SHOP), Carvana (ticker: CVNA), to name a few, dropped massively this year, it should be clear from the DCF formula that as interest rates go up, the future value of cash flow discounted to the present starts to drop drastically, and the markets, to the degree they are efficient, will rerate the stocks.

It is also clear from the formula for DCF that it is more likely than not that no two people will arrive at the same valuation for a given equity. The tool of DCF in the hands of an analyst is only as good as the analyst’s estimates for the underlying expected growth rate and a guess on where the fed-fund rate is heading into the future.

As such, I do not believe in using DCF to come to a precise estimate for the fair value of a given stock. The tool is best used in my mind to get a range of values as a function of the assumed discount rate and growth rate.

The Figure below shows a 2D plot of NFLX fair value, which I estimated, using a time period of 10 years, as a function of growth and discount rate. The immediate takeaway from the Figure for me is the color bar, which lists the range of fair values for the firm under DCF.

For example, I can see a path to the valuation of NFLX in the $300 range, should interest rates taper down from the current 4 % range to ~2 % range with NFLX expected to grow at or above 45 % annualized.

The table below provides a range for NFLX fair value under the assumption of different growth rates. For example, at 50 % expected annualized growth, under an optimistic scenario, I estimate the fair value for NFLX today to be ~$330.

My job is to perform this analysis and then determine whether the stock is currently trading within any of these estimated range values, and then make a call on whether do these values make sense given the underlying assumptions on the growth of the firm and the fed-fund rate.

If I can convince myself that the stock market price is within the bounds of my fair value range, or at a discount to fair value, will I consider making a call on investing in the stock.

With this, I now have outlined my entire investment process for putting money to work in the public markets.

The investment process is summarized herewith as follows:

  1. Search for super-investor stocks
  2. Make a judgment call on these stocks as to their merit to qualify as “quality businesses”
  3. Perform a quantitative analysis of these quality stocks to get a sense of their historical performance.
  4. Do DCF analysis to get a range for fair value estimates.
  5. Add a margin of safety number to the DCF bound and determine whether the stock is trading at discount to fair value or within the expected multiple of fair value!
  6. Put money to work!
Value Investing