Despite many of the negatives that we hear about DCF-based **stock valuation** these days, it is still a mainstream method for **stock valuation** as part of fundamental **equity research**. In his 1992 Berkshire Hathaway (BRK.A) annual report concerning the DCF **stock valuation** method, Warren Buffett stated “In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” Many of the popular **stock market report** bands equity analysis resources that retail value-investors rely on utilize this **stock valuation** method. This article will examine the strengths and weaknesses of DCF-based intrinsic value calculations and why it is importing for **value investing**.

Let’s review the main weaknesses of DCF-based **stock valuation**.

The first is that it requires us to predict cash flows or earnings long into the future. Data shows that most equity analysts cannot predict next-year’s earnings accurately. On a macroeconomic level, the “experts” have a terrible track record in predicting jobless claims, the year-end S&P, or GDP. This is no different when it comes to projecting the future cash flow of a business when picking stocks. We have to admit to ourselves that we have tremendous limitations in the ability to forecast future cash flows based on past results and recognize that a small error in the forecast can result in a large difference in the **stock valuation**.

The second challenge is determining the appropriate discount rate. What is the discount rate? Should we dust off our college or graduate school notebook and look at the CAPM, which calculates the discount rate as the risk-free rate plus the risk premium?

Well, since this I learned this formula from the same guy (by business school finance professor) that convinced me as a 22-year old, wet-behind the ears student that markets are efficient, I am skeptical. The most famous value investor Warren Buffett’s public comments about the issue have evolved as he has stated that he uses the long term US treasury rate since he tries “to deal with things about which we are quite certain but reminded us in 1994 that “In a world of 7% long-term bond rates, we’d certainly want to think we were discounting the after-tax stream of cash at a rate of at least 10%. But that will depend on the certainty that we feel about the business. The more certain we feel about the business, the closer we’re willing to play.” I’m inclined to take these seemingly contradictory guidelines from Buffett and from there derive a reasonable estimate of the discount rate as part of my **stock research**. With the September 1, 2011 30-Yr treasury yield at 3.51%, we must think that our discount rate for large cap stocks is closer to 10% than to the risk-free rate.

Finally, the problem with determining a feasible growth rate is that a DCF will simulate the growth rate to be eternal, and we know that no business can sustain an above-average growth rate in perpetuity.

Let’s now move to the strengths of a DCF model as a **stock valuation** tool.

George Edward Pelham Box, a Professor of Statistics at the University of Wisconsin, and a pioneer in the areas of quality control and experimental models of Bayesian inference famously remarked:

All models are wrong, some are useful.

I would argue that the DCF model can provide a useful **stock valuation** estimate as part of fundamental **stock research** if the user follows the following principles:

1. Invest in companies that have a sustainable competitive advantage. Stock investing should be though of as ownership interests in these companies

2. As Buffett alluded to in his 1994 letter, certainty in the business is essential. I therefore look at different measures of stability in revenues, earnings, book value, and free cash flow as part of my **equity research**

3. Your **stock research** should include through due diligence in analyzing companies financials (income statement, balance sheet, cash flow statement, efficiency ratios, and profitability ratios over at least a 10-year period of time

4. Before using a DCF **stock valuation** model or a PE and EPS estimation method for valuation, kick the tires by using a valuation model that requires no assumption of future growth. Jae Jun at www.oldschoolvalue.com has some very nice articles and examples on this topic (reverse DCF and EPV). I like to use the Earning’s Power Value (EPV) model (described below)

5. Look at simple relative valuation metrics such as P/E, EV/EBITA, PEPG, P/B etc

6. Employ conservative assumptions of growth and a discount rate between 8-13%

7. A healthy dose of intellectual honesty is needed so as not to modify the key growth and discount rate assumptions to arrive at a pre-conceived intrinsic value

8. Always use a Margin of Safety!

As mentioned, I am a big fan of Professor Bruce Greenwald’s Earnings Power Value calculation. Earnings Power Value (EPV) is an estimate of **stock valuation** that puts a value of a company from its current operations using normalized earnings. This methodology assumes no future growth and that existing earnings are sustainable. Unlike discounted cash flow models, EPV eliminates the need to predict future growth rates and therefore allows for more confidence in the output. It is a valuable tool as part of thorough **equity research** .

The formula: EPV= Normalized Earning’s x 1/WACC.

There are several steps required to calculate EPV:

1. Normalization of earnings is required to eliminate the effects on profitability of valuing the firm at different points in the business cycle. This means that we consider average EBIT margins over the past 10, 5, or 3- years and apply it to current year sales. This yields a normalized EBIT.

2. Subtract the average non-recurring charges over the past 10 years to the normalized EBIT.

3. Add back 25% of SG&A expenses to, as a certain percentage of SG&A contributes to current earnings power. We use a default add back of 25%. This assumes that the company can maintain current earning’s with 75% (1-input) of SG&A. The input range can be 15-25% depending on the industry. Where applicable, repeat for research and development expenses.

4. Add back depreciation for the current year. We use a default add back of 25%. This assumes that the company can maintain current earning’s with 75% (1-input) of capital expenditures. The input range can be 15-25% depending on the CapEx requirements of the industry.

5. Subtract the net debt and 1% of revenues from normalized earnings (this is an estimate of cash required to operate the business)

6. Assign a discount rate (or calculate WACC if you wish).

7. Earnings Power of Operations = Earnings of the firm * 1/cost of capital

8. Divide the EV of the firm by the number of shares, to get Price per share.

The DCF **stock valuation** model

In this 3-stage DCF model, free cash flow growth rates for years 1-5, 6-10, 11-15, and the terminal rate, are estimated. The sum of the free cash flow is then discounted to the present value.

The formula for a DFC model is as follows:

PV = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k – g)] / (1+k)n-1

Where:

• PV = present value

• CF1 = cash flow in year I (normalized by linear regression or 10, 5, 3-yr average of FCF)

• k = discount rate

• TCF = the terminal year cash flow

• g = growth rate assumption in perpetuity beyond terminal year

• n = the number of periods in the valuation model including the terminal year

Again, we must recognize that intrinsic value that is produced by our model is only as good as the numbers put into the model. If as part of our **stock research** we assume unrealistic growth rates (or terminal value), or discount rates, you will get an unrealistic intrinsic value result. No **stock valuation** model is going to magically provide the completely accurate intrinsic value but, if you are conservative and intellectually honest, and dealing with a company with solid underlying economics in addition to a long track record, you can find this method useful in identifying stocks that are priced below their intrinsic value. Buffett seemed to do OK for himself using this methodology so, if you follow the above principles, you can too.

Author says that, the article is briefly explaining the points like **stock valuation**, **equity research** and **stock research** for **value investing** and to generate a proper **stock market report** . You can also visit **www.marginofsafetyportfolio.com** for further details about all these.