Estimating Intrinsic Value in Practice

Putting the pieces together

Last lesson you met every input the discounted cash flow (DCF) model needs — a way of estimating what a business is worth by projecting the cash it will produce and converting that future cash into today's money. You learned where growth rates come from, why a terminal value stands in for everything past your forecast, why a discount rate shrinks distant money more than near money, and how the capital asset pricing model (CAPM) gives you a defensible rate to discount with. You also learned which direction each input pushes: faster growth or a higher terminal value raises your estimate, a higher discount rate lowers it.

You have the parts. This lesson assembles them.

There's no spreadsheet to download here, and that's deliberate. A calculator that hides the arithmetic teaches you to trust an output you can't check. Instead we're going to run the whole model once, by hand, on a company that doesn't exist. Follow it with a piece of paper or any spreadsheet you like. Once you've done it once, you can do it for any company — and more importantly, you'll know which assumption to blame when the answer looks strange.

Video coming soon

This lesson explains the idea in full without it.

The six steps

Every DCF estimate, no matter how elaborate, is these six moves in this order.

Steps 1 through 4 are judgment. Steps 5 and 6 are arithmetic. Almost everything that goes wrong with a DCF goes wrong in the first four.

Running it on XYZ

Meet XYZ, a fictional company. Every number below is invented and round, chosen so you can check the math in your head. A real company will never hand you figures this tidy.

Step 1 — the starting cash flow. XYZ's TTM EPS is $2.00. That's the last four reported quarters of profit, divided by shares outstanding.

Step 2 — project five years. Assume XYZ grows earnings 10% a year for five years. Each year is the prior year times 1.10.

Step 3 — the terminal value. XYZ's industry trades at an average P/E of 15, and we'll use that as the exit multiple. Multiply it by year five's EPS:

15 × $3.22 = $48.30

That $48.30 is a rough stand-in for what someone might pay for a share of XYZ five years from now, given everything the business is expected to earn after that.

Step 4 — the discount rate. Assume CAPM hands you 12%. That's what an investor should want per year for taking on XYZ's risk, and it's the rate we'll use to drag those future dollars back to today.

Step 5 — discount everything. Divide each future amount by 1.12 raised to the number of years away it is. Year three gets divided by 1.12 × 1.12 × 1.12, and so on.

Step 6 — add them up. $1.96 + $1.93 + $1.89 + $1.86 + $1.83 + $27.41 = $36.88.

Your estimated intrinsic value for XYZ is about $36.88 a share. That's the whole model.

Figure

Look at that last column before you move on. The five projected years contribute $9.47 between them. The terminal value contributes $27.41 — roughly three-quarters of the estimate. That is normal, and it is the most uncomfortable fact about the DCF model: most of your answer comes from a single number built on an exit multiple you picked. Change that multiple from 15 to 12 and the terminal value drops to $38.64, its present value drops to about $21.93, and XYZ is suddenly worth about $31.40. Same company, same earnings, one assumption moved.

Your estimate is not a price

Here is the part that matters more than the arithmetic.

You now have $36.88. Suppose XYZ trades at $30. It is tempting — genuinely, powerfully tempting — to treat this as a signal: the price is below my number, so buy. That conclusion misses the entire point of the exercise.

$36.88 is an estimate assembled from four guesses about a future nobody has seen. The market price is a fact. When your estimate and the price disagree, the honest first thought is not "the market is wrong." It's "one of us is, and I built mine out of assumptions this morning." Your estimate will usually differ from the price by a lot. That's expected, and it isn't information on its own.

What turns the estimate into a decision is the margin of safety — the gap between your estimated intrinsic value and the price you'd actually pay, expressed as a percentage of your estimate. It exists because you will be wrong. Not might be. Will be, regularly, about growth rates and multiples and how the next five years go. The margin of safety is the room you leave for that.

For XYZ at $30:

($36.88 − $30.00) ÷ $36.88 = 18.7%

So the price is below your estimate, and the margin of safety is still under 19%. If your investing plan requires more room than that — the next lessons cover how to set that threshold and where it goes in your plan — then XYZ is not a buy at $30. It's a name on a watch list with a price you're waiting for. To clear a 25% margin against a $36.88 estimate, you'd need XYZ at $27.66 or lower.

Run the loss case too. Suppose you buy XYZ at $30 and growth comes in at 4% a year instead of 10%, because a competitor shows up in year two. Rerun the six steps with 4% and the estimate lands near $28.76 — under the $30 you paid. The company you thought was undervalued was fairly priced or worse, and the market saw something you didn't. A margin of safety wouldn't have made that forecast right. It would have meant you only paid for XYZ at a price where being that wrong still left you somewhere to stand.

What to carry out of here

The six steps are a discipline, not an oracle. They force you to state what you believe about a company's growth, its risk, and what it'll be worth when you're done — in numbers, where you can be checked. That's worth doing even when the answer is "I don't know enough to fill in step two," because that's an answer too, and it's the one that saves you money.

Nothing here tells you what to buy. It tells you how to price your own beliefs, and how much room to leave for the strong possibility that they're wrong.

Key takeaways

• A DCF estimate is six steps: start with current cash flow, project it five years, estimate a terminal value with an exit multiple, pick a discount rate, discount everything to today, and add it up.
• Steps 1 through 4 are judgment calls; only steps 5 and 6 are math. Errors live in the judgment. Choose your assumptions before you look at the price.
• The terminal value usually dominates the estimate, so the exit multiple you pick moves the answer more than almost anything else. Small assumption changes produce large valuation changes.
• Your estimate is not a price and it will usually disagree with the market. That disagreement is not a buy signal by itself.
• The margin of safety decides — the gap between your estimate and the price, sized to absorb the fact that you will sometimes be badly wrong. A price merely below your estimate is not enough.