A NEW WAY OF APPROACHING THE DISCOUNTED CASH FLOW VALUATION (DCF)

Introduction:

The stock market is not an easy place. The amount of information and the complexity of the latter makes it hard to play the stock game. To win in such a difficult environment, I tried to come up with a different approach to downsize my risk when investing.

One important criteria when purchasing a stock is the price. Are you buying cheap? Is the stock too expensive compared to its intrinsic value? The difficulty for determining the price comes from the fact that we can't predict the future of any company. It also comes from the fact that we have a tendency to follow our emotions when investing.

When we evolve in an optimistic environment, we are more inclined to become very optimistic as well. It impacts our assumptions when we value the targeted company through a Discounted Cash Flow (DCF). At which rate am I supposed to grow earnings over the years? Should I create a good, medium and bad scenario when making the projections? Well, I don't follow any of those "institutional" methods. Worst, I assume that to get closer to the reality of the future of any company, we need thousands of scenarios.

I have implemented that philosophy in all the stocks I try to value.

Discounted Cash Flow 3.0:

If you let me have a look at the last 50 000 days of your life, I would be more enclined to predict what will your future be. It is the same thing for a company.

We all have this tendency to magnify the growth rate of earnings and assume lower risks in a bull market. We do exactly the opposite during a bear market. To avoid including emotions in the process of valuation, I developped a DCF based on a Monte-Carlo Simulations.

What's the idea behind it? Who tells me that the company I am valuying will have a constant earnings growth rate over the years? Who tells me that the company will not experience a decrease of revenues? Nobody knows about that.

The purpose of my model is to create 50 000 scenarios for the Free Cash Flow projection of the firm based on a range of assumptions. For example, I will assume that the Net Income will experience variations between -20% and 20% for the next 10 years. The same for the Non-Cash items, the change in Working Capital and the Capital Expenditures. Each year, we will have different scenarios that can be very good or very bad for the firm. The ultimate goal is not to give a precise value of the stock - as it is the case today for many valuation templates and examples-, it is rather to give a range in which you are sure with a certain level of confidence that the stock is not below or above some price.

Any person that tells you that the stock of Apple Inc. is worth 158 dollars and 56 cents is lying to you. My model is not based to provide this kind of conclusions. It is rather meant to tell you that the fair value of  Apple's stock is situated somewhere between 120$ and 190 $ after 50 000 different scenarios of how could behave the free cash flow. If you see the stock price going under 120$ it provides even more margin and increases your probability to be right. It may sound strange, but I actually found some very interesting stocks with it.

Gilead Sciences and Valero are two stocks for which I found a 25% margin of safety when performing the simulation of 50 000 potential free cash flows. They will be presented on the next article.