I have been trying to build a spreadsheet to do a DCF calculation based on everything I have read. The spreadsheet is here:
https://drive.google.com/file/d/0B5s9XNYb_n7pdk5TTjdXMUlmeWs/view?usp=sharing
The thing is, I am struggling to define a YoY Earnings Growth Rate. In my mind I think this should be the % increase of 'Operating Cashflow' from the Cashflow statement and I wondered if anyone else has a definition for the % growth they use in their DCF calculation.
Maybe it's better to 'form an opinion' by listening to the company webcasts or reading the annual reports, and to not obsess on finding a percentage. I don't know and would like other peoples opinions.
Andy
Hi Andy,
Personally, I have moved away from calculations like this for valuation due to their tendency to lure you into a false sense of security. As with all of these things, the rule is GIGO - garbage in, garbage out. It is very hard to estimate the variables to any precise degree of utility, precisely the problem you are having. I don't really think they improve my decision on valuation beyond what eyeballing some simple valuation ratios and taking a look at the balance sheet does - just my opinion though.
That said, here are my thoughts on two ways to approach the problem (both are simple and there are other ways!):
1 - The academic way (not preferred (by me!)): There is a formula in academic finance for the 'sustainable growth rate' of a firm. It is actually quite logical and goes as follows: g = ROE * (1 - p), where: g = sustainable growth rate, ROE = return on equity and p = the dividend payout ratio.
It is logical because this is essentially asking the question, 'at what rate can I expect equity (book value) to grow, after dividends have been paid?'. ROE is the % return on equity for a given period, so if we take away the dividends that we pay out of that return ( the (1 - p) part), then the resulting rate is the % amount that book value grew by in that period.
To make this a more realistic calculation, it is probably better to take the average ROE and p rates over the past few years to ensure you are not using an unusually high or low figure for the company. This calculation, in my opinion, is only really of any use when we're talking about very mature and steadily growing businesses and even then it cannot account for potential changes in the growth rate. All in all, not a method I put much value in - at least it often comes out as quite conservative though.
2 - The margin-of-safety method (preferred (by me!)): This would involve making a guess at a range of values for the growth rate which you are very certain (never 100% certain but maybe 90%) that the growth rate will fall within over the future. For example, if we're talking about a big, mature company we might say that there is no way it's going to grow at 15% a year, maybe it'll do 10 at a push, there's a good chance it will just trundle along at the rate the economy grows, and there's a chance it will do a fair bit worse than that, maybe even shrinking a few % a year.
You then perform your DCF calculation across that range you have established, and compare the potential values with the current market price. If you find the current price fits right down at the bottom end of your estimation range (or, ideally, below it!) then you may well have found an undervalued company. If it's sat somewhere in the middle of your range or near the top, then it's probably roughly fairly valued.
I think it's important to remember that you cannot precisely predict the value of a given company with these methods. However, they can work as a barometer to indicate when the current valuation is way out. It is probably better to be too prudent than too optimistic so try to avoid factoring in the possibility of very high growth rates. If the investment relies on the firm achieving exceptionally high growth rates for a long period of time then unless you really do know something that no one else does, it's probably not a good idea.
Hope that helps, feel free to ask any questions and/or disagree etc.
Tom
