Learn Financial Modeling: Discounted Cash Flow statement (DCF) Methodology
5. Discover our Intrinsic Value and its meaning
We could go ahead and calculate enterprise value which is the sum of our stage one plus stage 2, but we are concerned with equity value. We need to go from enterprise value to equity value. How do we do that? We need to subtract out net debt. In other words, equity value equals enterprise value less net debit. Keeping this formula in mind we will calculate net debt.
I know most of you are thinking we will just use plain vanilla debt. The truth is you want to use all gross debt or all non-equity claims. Such items could include gross debt as well as preferred stock minority interest. Really anything that is considered a non-equity claim that we want to subtract out from enterprise value to arrive at equity value. In our case we are using net debt from the balance sheet which is total debt less cash and cash equivalents. The whole idea with net debt on Wall Street is that practitioners believe that if you have excess liquidity you can pay off some of that debt. We are going to assume that, so enterprise value less net debt provides our equity value. If we bring in our diluted share count, we can figure out on a per share basis what the equity value per share is.
Now we have our equity value per share. From this we can go back to the Financial Summary to see what the recommendation is. You can see alongside DCF Unlevered the stock projected value with a strong sell recommendation. If you look above that you will see that AAPL is rated a strong buy with a 5-star rating. This recommendation is from using a weighted average from all the categories on the right. Now you can see how you can use this powerful analysis to make decisions for investments or trading or whatever it is you might be doing with DCF analysis.
Just to quickly recap. We forecast free cash flows into the future for our explicit forecast period. Then we discount back to the present using a discount rate that reflects the riskiness of capital. We use WACC because we want to use a discount rate that is available to all providers of capital. That gave us our stage 1 value. Then we calculated stage 2 which is the value beyond the explicit forecast period with a constant growth rate. This value was then discounted back to the present using WACC. Adding stage 1 and stage 2 gave us the enterprise value. From enterprise value we subtract out net debt which gives equity value. We divide the equity value by the number of diluted shares giving us equity value per share. We can compare this value to the stock market value to make a decision.
Go back to discounted cash flow