The DCF method is a great method you can use to value a company. However, as any valuation method it has limitations and is sensitive to the parameters you use. Here we'd like to help you understand the DCF method better.
Before we dive in, a quick note on modelling/estimating/predicting in general, be it financial, climate or any other topic. Any model that tries to predict the future will be inherently wrong. No one can predict the future and the more complex a model is, the more assumptions you make, the more wrong you'll be. This is both why the tools we provide are enough to aid you in your investment decisions, and why it is really important that you understand the assumptions you make and the company you are analysing while using the analyzer. The intrinsic value you get from the analyzer is a rough estimate, and to quote a famous investor:
"It is better to be approximately right than precisely wrong."
Based on historical numbers we find the best fit growth rate. Then, project future revenue and calculate free cash flow (FCF) from the average FCF margin, which is then discounted back to the present. Add equity and a terminal value. Divide by number of shares outstanding and you get the value per share. Now, onto the parameters.
Be aware that you need some financial history to use the method. We recommend at least 3 years of financial reporting. Generally, the shorter period, the more uncertainty and noise, but also more responsivity. Great companies, however, perform over many years and will be easier to value. Also, do not use the model on companies with average free cash flow margin less than 0, as this will result in a negative valuation, which does not make sense.
There are a few different ways to pick the required return. If you use the weighted average cost of capital (WACC) for a company, the value estimate you get will be the most realistic. However, when you estimate value you want to play it safe. One common approach is taking the risk free rate, the ten year US treasury yield, and add 10%. The pro of this approach is that it accounts for the rise in interest rates. Interest rates are like gravity to the stock price (Warren Buffet paraphrased). The con is that you may end up not buying at the best times because your model was too strict. Stock markets usually bottom when the interest rates peak.
Another approach is to pick a static number. By doing so, you set the bar and when the markets go down you have a hard limit for when you will start buying. The con is that you never know how high rates will become or how low the markets will go. We recommend a minimum value of 10-12%, this is slightly more than the average annual return of the S&P 500 index.
The perpetual growth rate (PGR) is used to calculate the terminal value. The assumption means that the company will grow at this rate till the end of time. Wait... won't this mean the value will be infinite as well? Well no, the required return/discount rate makes the present value of returns far into the future go towards 0 and you can calculate a terminal value.
Traditionally you would "pick a rate between the historical rate of inflation in the US at about 2-3% and the historical US GDP growth rate of about 4-5%". However, since the early 1960's the average US inflation rate has been 3.76% while the average US GDP growth rate has been 2.97%. Honestly, inflation greater than GDP growth over time is bad. For the time being we recommend using 3.0% as the PGR, tell your family you love them, and hope this development turns around in the future.
This parameter lets you adjust for any changes in the shares outstanding. A default value is recommended based on the numbers you enter in the model. However, to pick the correct value you need to know the company you are analysing. An unprofitable company may issue new shares (dilution) to raise capital, but once they reach profitability and can survive without external funds, they may stop diluting existing shareholders. Likewise, a company buying back shares (concentration) may experience a drop in profitability and stop the buybacks. Please read up on the company and their plans to pick the right value.
We will automatically recommend the average free cash flow (FCF) margin calculated from your numbers as the default value. There are three ways we can get the FCF margin and you only need to enter one. 1) Enter revenue and free cash flow. 2) Sometimes free cash flow is not reported in the financial report, then you can replace free cash flow with operating cash flow and capital expenditures and we'll automatically calculate the FCF margin. 3) Some companies does not have financial reporting on this level, you may then approximate the FCF margin by using the net result/profit/loss.
This parameter sets the number of columns you can enter numbers in. It also sets the period over which the recommended values are calculated and for how far into the future we will project the trend growth. Picking a longer period gives a more reliable projection, but it will be less responsive to changes in the company performance.
Q: Why don't you use analyst consensus estimates in the projections?
A: Analysts are as wrong as anyone else, valuation isn't exact science, you don't need the false precision.