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How to calculate Intrinsic Value using Discounted Cash Flows (DCF) – Show Outline
What is Intrinsic Value?
- The present value of all future free cash flows produced by a business.
Time Value of Money
- Cash today is worth more than cash in the future.
- Therefore, you need to discount future cash flows to be worth less than their stated value.
The simplified discounted cash flow formula
- Intrinsic Value = Owner’s Earnings/(Discount Rate – Growth Rate)
- Discount Rates: 10% (nominal) or 6.5% (real)
- Growth Rates: Bounded between 0% and 5%
- Owner’s Earnings: Manually calculated by adjusting Net Income
Complex Discounted Cash Flow Calculations
- When to use:
- Company is in a high-growth phase of its business (has not yet saturated the market)
- You are highly confident in short-term projections and the business is predictable
- Reported earnings have a lot of temporary adjustments that make the next few years not match the long-term
- When not to use:
- Almost always
- Complex calculations can trick you into thinking you have a better understanding of the business than you do
- You’ll likely rely heavily on growth and fast growth assumptions are very risky to make
- Part 1: Episode 23 – Discount Rates
- Part 2: Episode 25 – Long-Term Growth Rates
- Part 3: Episode 26 – Owner’s Earnings
- Example Intrinsic Value Reports [$10+/month Patrons receive exclusive access]