With the market becoming increasingly focussed on the short term earnings outlook for a company, I thought it would be worthwhile stepping back to first principles: how do we determine what a business is worth? The idea of a stock being worth the present value of all the future cash flows it would generate was first postulated by **John Burr Williams**, in his 1938 book *The Theory of Investment Value*, where he introduced the world to the discount cash flow (DCF). This concept has become widely accepted as the method to determine an assets fair market value.

How does a DCF work?

- Forecast 10 years worth of profits (usually using a fixed growth rate – GR)
- Decide on an appropriate discount rate (DR) (usually the 10 year Government bond rate + some extra interest rate for the risk associated with an equity investment)
- Decide on an appropriate
*terminal value growth rate (TVGR)*(usually 2-3% or the long term GDP growth rate)

Once you have collected the required data, each forecast year is “discounted back” to the present, by your required discount rate. This is to adjust future dollars so that they can be compared with today’s dollars – because $1 in the future is not worth as much as $1 today due to inflation.

The discounting factor = value / {(1 + DR)^Year}

i.e. In the example below, the present value of year 5’s profit equals:

= 1.75 / { (1+10%)^5 }

= 1.75 / 1.61

= 1.09

Therefore, a company that currently earns $1 in profit, and can grow those profits at 15% per annum for the next 10 years, is worth ~$28 based on the discounting assumptions.

How does this relate to long-term thinking?

By breaking the DCF down into cohorts of various years, we can see how different time periods contribute to the overall present value of the company.

In the example above, I’ve broken the DCF into three sections:

**a** – The cash flows from the first 5 years of the forecast period

**b** – The cash flows from the second 5 years of the forecast period

**c** – The terminal value (the value of the final years cash flow growing at the terminal growth rate – 2% – into perpetuity)

The breakdown of value for the above example is as follows:

- Years 1 through 5 contribute 18% to the total DCF of the company
- Years 6 through 10 contribute 22% to the total DCF of the company
- The terminal value contributes 60% to the total DCF of the company

Therefore, 82% of the companies present valuation is being ascribed to profits earned over five years away!

The faster a company is growing (or expected to grow) the more value that will accumulate in the later years of the DCF. However, even for companies that do not grow, well over half of the current valuation is attributed to profits earned in years 5+

Therefore, when investors send a stock price down 20%+ on the back of one quarters earnings, they are either overreacting or have completely changed their 5+ year outlook for a companies earnings, because next years earnings contribute less than 10% of the valuation of a company!

What about the terminal value?

As shown in the chart above, the lions share of present value is attributed to the terminal value of a company. This is a shorthand way of determining what a company’s cash flows are worth in perpetuity. It’s calculated by simply taking the profit from the final year of the forecast period and dividing it by the discount rate, less the expected long term growth rate of the firm.

I like to call the terminal value calculation *simple, but dangerous!* This is because, many sell-side analysts use an aggressive long term expected growth rate, to justify the current valuation of high growth stocks. There’s a quote by Curtis Jensen that sums up the power of a DCF aptly:

*“Discounted cash flow to us is sort of like the Hubble telescope – you turn it a fraction of an inch and you’re in a different galaxy.”*

If we take the earlier example of a company growing at 15% per annum (with a 10% discount rate and 2% terminal growth rate) and increase the terminal growth rate by 1% the present value increases 9% to over $30. If we increase it from 2% to 5% (which many sell-side analysts often do) the present value increases by over one third to $38!

For this reason, I always keep a flat TVGR of ~2% to be conservative.

How useful is all of this if we can’t forecast profits?

The idea behind a DCF is elegantly simple, however, the premise upon which it is built, the ability to forecast 10 years worth of profits, is ultimately flawed. Predicting what a business will be earning in 5+ years with any degree of certainty is a fool’s errand. For example, *Floppy Disks *went from being ubiquitous to completely unheard of in less than ten years!

Therefore, if we can’t forecast a businesses long run profitability, how can we be “value” investors? The answer requries “some” conservative forecasting and using **Charlie Munger’s mental model of inverting**. The **reverse DCF** uses Williams’ theory, but instead of requiring 10 years worth of profit forecasts, it uses the current share price to determine *the implied profit growth.*

To explain how it works, let’s use a real-world example – **Apple**

**Data**

- Last year AAPL made ~$46bn in profits
- Net cash of ~$150bn
- 5.3m shares on issue
- Current share price is $164

**Assumptions**

- Discount rate 10%
- Terminal growth rate 2%

Plugging this data into my *implied growth calculator*, which uses a macro to adjust the earnings growth rate until the NPV (valuation) is equal to the current share price, generates an **implied growth rate of ~6%**

Now the conservative forecasting side comes in, where you as the analyst/investor have to decide whether this growth rate is conservative, aggressive or about fair. If you decide that AAPL is extremely likely to grow at more than 6% per annum for the next decade, it may very well by a buy at current levels.