Discount to Fair Value Calculation

In value investing, accurately estimating a stock’s fair value, also known as intrinsic value, is paramount. Our advanced stock screeners leverage the Discount to Fair Value metric to swiftly identify potentially undervalued stocks. This comprehensive guide delves into how this metric is calculated using two robust approaches: Free Cash Flow and Net Profit.

The Discounted Cash Flow (DCF) Method

The Discounted Cash Flow (DCF) method is a cornerstone technique in estimating the value of a business based on its projected future cash flows. This method operates under the principle that the value of money diminishes over time, making future cash flows less valuable than present ones. Here’s how we apply the DCF method:

1. Projecting Future Cash Flows:

   We begin by forecasting the company’s future cash flows, including a terminal value that accounts for cash flows beyond the projection period.

2. Discounting to Present Value:

   The projected cash flows are then discounted back to their present value using a specified discount rate, which represents the desired rate of return, akin to the cost of equity.

The core principle behind DCF is that the present value of expected future cash flows can provide a more accurate estimate of a company’s true worth, aiding investors in making informed decisions.

Free Cash Flow and Net Profit Approaches

Our stock screeners employ two distinct approaches to estimate a stock’s fair value, ensuring a comprehensive evaluation of the company’s financial health:

1. Free Cash Flow:

   This approach focuses on the actual cash generated by the company after accounting for capital expenditures. It reflects the company’s ability to generate cash from its operations, highlighting its financial health and operational efficiency.

2. Net Profit:

   This method examines the company’s profitability and earnings power. By analyzing net profit per share (equivalent to earnings per share or EPS), we assess the company’s capacity to generate income and sustain its operations over time.

Utilizing both approaches allows us to gain a holistic view of a company’s financial position, ensuring that our fair value estimates are both accurate and reliable.

Approach 1: Free Cash Flow

1. Determine Historical Growth Rate:

   We calculate the historical free cash flow growth over the last 10, 7, 5, and 3 years, selecting the longest available period to establish a reliable growth rate.

2. Apply Growth Rate Cap:

   To maintain a conservative estimate, growth rates exceeding 20% per annum are capped at 20%. This accounts for the difficulty businesses face in sustaining high growth rates over extended periods.

3. Project Free Cash Flow:

   Using the selected growth rate, we project the current free cash flow per share over a 10-year horizon.

4. Calculate Terminal Value:

   We apply a terminal Price to Free Cash Flow (P/FCF) ratio of 15 to determine the terminal value at the end of the 10-year projection period.

5. Discount to Present Value:

   Both the projected free cash flows and the terminal value are discounted to their present value using a 12% discount rate, aligning with the default rate in our Intrinsic Value Calculator.

6. Estimate Fair Value:

   The sum of these discounted cash flows provides an estimate of the stock’s current fair value or intrinsic value.

Approach 2: Net Profit

1. Historical Growth Rate Determination:

   We calculate the historical net profit growth over the last 10, 7, 5, and 3 years, selecting the longest available period to establish a reliable growth rate.

2. Growth Rate Cap:

   To ensure conservatism, growth rates exceeding 20% per annum are capped at 20%, acknowledging the challenge businesses face in maintaining high growth rates over extended periods.

3. Projection of Net Profit:

   Using the selected growth rate, we project the current net profit per share (equivalent to earnings per share or EPS) over a 10-year horizon.

4. Terminal Value Calculation:

   We apply a terminal Price to Earnings (P/E) ratio of 15 to determine the terminal value at the end of the 10-year projection period.

5. Discounting to Present Value:

   Both the projected net profit and the terminal value are discounted to their present value using a 12% discount rate.

6. Estimating Fair Value:

   The sum of these discounted values provides an estimate of the stock’s current fair value.

Discount to Fair Value Calculation

For both approaches, the Discount to Fair Value is calculated as:

(Fair Value Price – Current Stock Price) / Fair Value Price

Conclusion

The Discount to Fair Value metric offers a quantitative foundation for evaluating stocks. However, it’s important to recognize that past growth does not guarantee future performance. Investors should consider different terminal value ratios or discount rates based on the specific characteristics of each stock.

The fair value estimated by the Discount to Fair Value metric can be further validated using the Intrinsic Value Calculator with specific assumptions tailored to your investment strategy.